The False Hope Of Equity Income Funds

18th Jan '11 by Rob Davies

34 comments 14940 reads

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…

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Rob Davies

25th Jan '11

Daytona,

I don't think there is a difference. From what I can see that is a total return study. The high yield gives it a value bias and that confirms that a value bias adds value. It doesn't say how many stocks it held or if the portfolio gave a higher yield than the market.

Emptyend.

Sorry for the confusion. In the past we have referred to gross dividends but people complained because that has tax implications.

StrollingMolby

Interesting discussion - so how has this approach to income fared over say 1, 3 & 5 years, and against the benchmark index?

The income approach is a tool to give the portfolio a value tilt. Not to generate income.

It was launched in September 2007 so only has data for three years.

At 10th Jan the fund had risen 8.1% over the previous year against 9.1% for the FTSE 350 Index and 12.6% for the FTSE 350TR.

Over three years the fund is down 2.9% against 1.8% drop for the index and a rise of 10% for the TR index.

Those figures need to be viewed in context. The fund has a substantially lower aggregate valuation than the index because the value tilt means it is underweight many stocks, like Arm Holdings (LON:ARM), that are now on high valuatuions.

I can answer my own question now, having visited http://www.themunrofund.com/index.php and Trustnet.

	Since Launch	3 Yr	2 Yr	1 Yr	6 Mth	3 Mth
Munro X Acc	-7.0%	-2.9%	35.0%	8.1%	16.6%	5.9%
FTSE 350 Index	-6.0%	-1.8%	38.1%	9.1%	16.4%	5.6%
FTSE 350 TR Index	-6.0%	10.0%	48.5%	12.6%	17.9%	6.2%

Source: Fundamental Tracker Investment Management Limited

So the data shows that The Munro Fund's returns lag behind the total return of the FTSE350 over every time period. Would investors be better off in a tracker?

Performance

IN September 2007 when the fund was launched the forecast total dividend income for the FTSE 350 was £72 billion. Three years later it is £68 billion; about 5.6% lower. Over that period the fund has declined 7% as was pointed out yet the FTSE TR index has risen 6%.

So the market is now putting a higher valuation on a smaller pot of earnings. That maybe right, who knows?

But the fund offers exposure to that income stream at a lower valuation than the market.

The historic data on total forecast income is at the bottom of this page

http://www.themunrofund.com/0605_history.html

snaj

"IN September 2007 when the fund was launched the forecast total dividend income for the FTSE 350 was £72 billion. Three years later it is £68 billion; about 5.6% lower. Over that period the fund has declined 7% as was pointed out yet the FTSE TR index has risen 6%.

So the market is now putting a higher valuation on a smaller pot of earnings. That maybe right, who knows?"

Dividend income doesn't equal earnings surely? Payout ratio may have changed - e.g. by takeovers of dividend paying companies that are replaced in the index by non-dividend paying companies. Or companies are simply, like the rest of the economy, deleveraging - in their case perhaps by reducing dividends?

But again, I'm confused as you're referencing a change in total dividend income from the index with a change in capital value for your fund - what's the correlation?

In relation to the question I asked earlier, I'm still unclear as to why you're trimming a stock because it's capital value has changed relative to the market - I thought the model is based on the forecast total dividend weight? If the latter has changed then I understand why the tracker fund would adjust, but not otherwise.

Elsewhere I see that you refer to equity income funds not being able to hold much of say, Cairn Energy, and consequently that's a bad thing:

a) isn't your fund even more constrained in that respect? If so, seems a bit odd to be critical of the equity income sector

b) equity income funds are actually not as restricted as you imply - their income targets are set across the whole fund so many such managers are able to hold the likes of Cairn whilst holding other shares that pay much-higher-than-index yielders - the so-called 'barbell' strategy

If the point of the original article was to say that by buying equity income, you get a high starting income but less scope for increases in that income I don't think you would get much argument - muddying the point by saying that a high starting income leaves less scope for capital increases is where I take issue, not to mention a few other points that simply don't stand up to scrutiny - sorry to say that I don't think the article was either well-conceived nor well-executed.

emptyend

26th Jan '11

Yes they probably would have been....in the past.....though of course it depends on charges etc.

But McEssex makes a fair point that the approach means that they have been underweight growth stocks during a period (well the last two years anyway) when all the expectations have been for a conventional recovery which (AFAIAA) has led growth stocks to outperform.

After yesterdays Q4 -0.5% growth numbers, the jury (at best) must be out on that.

Personally I think it is a little difficult to get excited about the modest basis for differentiation....and, structurally, there is a bias against companies involved in exploration for oil and minerals (which are often modest dividend payers) - and I'd think (as you might expect!) that is generally a weakness.

djpreston

I've stayed out of this thread thus far but I have to say that I still don't "get" the point of the fund.

Holders are receiving a fund focussed on those with the biggest contribution to overall market dividend?

Seems to me that its a very restrictive fund mandate given a major bias to what are value stocks with no scope for addressing the other companies with low or no divis thereby potentially increasing the specific or opportunity cost risk surely?

If I don't "get" the fund then I'm sure other asset managers won't either, hence the small size (irrespective of performance).

For me, I like to know a manager's style and remit inside and out and I'm not averse to using small funds - Unicorn's Income fund is one of our core Equity Income holdings for instance and that was (is) tiny.

So long as people "get" the fund then it can be used (or not) and blended with other funds with different strategies (barbell etc) as required to match the asset manager's/investor's needs.

Snaj,

A stock is trimmed if it becomes overweight relative to the model.

djpreston

The point of the fund is to remove subjectivity and have a logical, arithmetically derived calculation for determining the weight of each stock in the portfolio.

That way you can manage risk and and avoid being overweight an expensive stock. It provides a discipline to buy into out of favour stocks such as BP Plc (LON:BP) last year when the fund tripled its holding as the shares fell from 650p to 300p.

The historic data demonstrates this has delivered lower volatility than the market.

That way you can manage risk and and avoid being overweight an expensive stock.

Well I take your point in respect of BP - but what happened (or would have happened) if the dividend stream of the banks had sucked you more and more into them during the financial crisis???

but what happened (or would have happened) if the dividend stream of the banks had sucked you more and more into them during the financial crisis???

The fund did have large holdings in the banks, especially RBS and HBOS before the crash in 2008. That was painful.

That was painful.

....and perhaps responsible for a very large slice of the underperformance, I imagine, given their heavy weighting and substantial capital losses.

dodge1664

Why did the fund load up on BP after it had axed its dividend?

The stock started falllng right after the accident. BP did not make a statement on its dividend until mid June.

The fund uses the consensus forecast for the next forecast year, at that time 2011. Analyst's did not change their estimates until after BP had made the statement which was about the same time as the meeting with Obama.

Although it was clear the dividend was under threat, and we sensed that, the process dictates that it uses the consensus of all the forecasts. Like the banks in 2008 the analysts were wrong but that is a drawback of the system.

Active funds, in theory, could have sold immediately at 600p and bought back at 300p. The problem is that at the time no one knew how bad the accident would get and what level the shares would fall to.

In early July the consensus had changed and the model used the new, lower, number.

This process is one attempt to apply discipline to a difficult, subjective problem.

Hi Rob

Thanks - I think my light bulb has finally come on with respect to how your fund is constructed the way it is - as you have daily dealing by investors in your fund, new purchases must be buying the 'model' so you have to buy more of a share that has fallen in value relative to the rest of the portfolio even though there has been no change in the relative forecast dividend.

With that out of the way, I think the BP situation you've described is interesting and whilst the fund will initially have taken a big hit, but then gone on to make decent money out of BP is purely down to the good fortune that a dividend is to be reinstated so quickly - what if the model had been forcing you to buy more through the summer as it fell to £3 ahead of the forecast dividend being cancelled, but the subsequent forecast dividend then was for reinstatement either not until 2012 or at a nominal level only - would you not then have had to sell substantially the entire position before the recovery in the share price to the current level, where you might then have been a buyer again?

The short time frame between cancellation and forecasts for reinstatement presumably meant that you didn't have to sell out of the much larger number of BP shares that were being purchased through the summer at the worst possible time, but if it had taken another six months for the well to be capped successfully or if BP had not been able to affect asset sales or if BP had had excess debt such that the dividend was unlikely to be reinstated for a number of years, then surely that worst case would have come about, just as with the banks in 2008?

I don't see the argument nor any evidence that a mechanical strategy such as yours is superior to an active equity income strategy in itself - yes, there will be dog funds in the equity income sector but there are also good funds too - both resulting from a function of the 'discipline' imposed and of the skill of the manager. I'm afraid that you haven't convinced me that the 'discipline' imposed in equity income is any worse than the more rigid constraints that result from your mechanical strategy.

Regards
Sanjeev

Rob,

It seems to me that the fund was lucky with BP and unlucky with the banks, so things have just averaged out.

Can you point me to any studies on the accuracy of analyst dividend forecasts? What makes you think they are reliable? I've read that analysts have a tendency to simply extrapolate the recent past as far as earnings are concerned.

Snaj,

The worst case scenario you described for BP actually happened to the banks in 2008/9. In the end we sold Royal Bank Of Scotland (LON:RBS) and HBOS was taken over at a low value. The holdings in Alliance and Bradford eventually became worthless as well. If a company totally blows up there is no escape.

Dodge

Overall, value has been out of favour over the last few years because of the banks, £BP. and, more recently, the massive QE injection and low interest rates has rewarded risk. This has beneffited small cap and growth stocks. The FTSE 250 is up 12% more than the FTSE 100 over the last year.

Analysts are not very accurate, they just rehash what the companies tell them. But then what position am I, or anyone else, in to make a better forecast? Even if someone was accurate how would you know? Would they always be accurate?

Besides , the forecast for Vodafone Group (LON:VOD) has not changed much of late but the stock is moving up. Sentiment is impossible to measure.

27th Jan '11

As an example yesterday's little rally in Vodafone Group (LON:VOD) took the position 0.297% overweight so stock was sold at 182.4p to maintain the fund at the model weight of 7.49%.

Rob,

So you trim Vodafone Group (LON:VOD) back a bit (and book a capital gain) but this reduces the future dividend to be received on that holding. And when the price falls you buy again to rebalance. So around your model portfolio you BLASH, and the fund's returns are a mixture of capital and income? How does the performance of the accumulation shares compare to the income shares?

Where will I find the Munro Fund Report & Accounts? I've just been looking for the fund literature on the Munro Fund website, FTIM website and Smith & Williamson but can't find it.

Whilst surfing though I did come across the December portfolio and am amazed at the comet tail of holdings. What contribution can those holdings as small as 0.01% (£210 of £2.1m fund) of the fund provide in gains and income?

And another thing! With the mechanical nature of the rebalancing the turnover of the fund and broker commission must be high - do you have annual figures for turnover and the TER?

SM,

All the Fund R & A's are on this page.

http://www.themunrofund.com/0601A_key_data.html

Prices are on this page

http://www.themunrofund.com/0603_prices.html

so you can compare the performance of income andaccumulation shares since launch at 100p.

Yes, the return is a mixture of capital and income. Funds taken out of overweights are reinvested in underweights. For example last Thursday the fund topped up on Anglo American (LON:AAL) at 3124.5p, British American Tobacco (LON:BATS) at 2289p, Imperial Tobacco (LON:IMT) at 1805p and Fresnillo (LON:FRES) at 1360p.

The long tail has no cost and as the fund gets bigger it is able to exploit volatility lower down the cap scale.

Turnover is 26%, but that is a bit misleading. Last year it only sold two complete holdings, Cadbury and Tompkins because they were taken over, the rest is rebalancing or investing new money.

TER is 1.7% but that high figure is more a function of the small size of the fund than the absolute cost base which is very low. Stamp duty costs us twice as much as commission.

The false hope of equity income funds

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Rob Davies

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