The false hope of equity income funds

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.

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%.

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.

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

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. 

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 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???

ee

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.

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.

"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.

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

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

  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? 

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.

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

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.

I'm afraid that your clarification about HSBC and the amount they will pay out leaves me just as confused. Are you saying that you select stocks on the basis of total dividends paid without consideration of market cap, number of shares in issue or share price? On that basis you will always pick HSBC, BP etc simply because they are vast, so in reality all you would be doing is selecting the largest mcap stocks in the index, provided they pay out at least something in dividends. It may work, but the rationale is not clear.

No, you are not confused, that is exactly what we do. We ignore valuations to construct the model and then populate the fund according to the model.

So all you are doing is weighting the fund with reference to total dividends rather than (the more normal) weighting by market cap.

Why didn't you say so?

The reference to "dividend income" in your earlier post was misleading - because the phrase is only meaningful if based on a particular amount of capital.  What you mean is the "gross dividend payout", and not "dividend income" or yield.

ee

Rob, how do you explain the difference between the theory and the reality as demonstrated in the following research precised in Tweedy Brown's - The High Dividend Yield Return Advantage -

"In a later paper, entitled Taxes, Dividend Yields and Returns in the UK Equity Market, Journal of
Banking & Finance (1998), Gareth Morgan and Stephen Thomas of the University of
Southampton also found a return premium associated with higher dividend yield securities, but their
data rejected a tax-based explanation since in the UK dividend income is taxed more favorably than
capital gains. Using data from the London Share Price Database (LSPD), they examined the
relationship between dividend yields and stock returns from 1975 through 1993 in the UK.
Database companies were ranked by dividend yield at the end of each month and divided into six
groups, including a zero dividend group (companies that did not pay dividends). In the table below
from page 12 of their study, Messrs. Morgan and Thomas find a strong correlation between the size
of the dividend yield and the average monthly return."

"In a paper entitled Stock Market Anomalies: A Reassessment Based on the U.K. Evidence, Journal of
Banking and Finance, December 1989, Professor Mario Levis, at The School of Management,
University of Bath, United Kingdom, examined a number of anomalies in stock price behavior of
firms on the London Stock Exchange, including the correlation between dividend yield and
investment returns. In a subsequent paper, entitled Market Anomalies: A Mirage or a Bona Fide Way to
Enhance Returns?, Michael Lenhoff of CapelCure Myers Capital Management, used data largely
derived from Professor Levis’ study to illustrate a strong positive relationship between dividend yield
and attractive rates of return. Using a sample of 4,413 companies, all of which were listed on the
London Stock Exchange during January 1955 through December 1988, Lenhoff ranked these listed
companies each year according to dividend yield and sorted the companies into deciles. The 34-year
compounded annual investment returns and cumulative values of an assumed ?1 million initial
investment in each of the ten groups is shown in the following table, along with descriptive
information concerning each group’s average dividend yield and market capitalization.
In his study, there was almost a perfect correlation in the decile returns between higher
dividend yields and higher annualized returns. The top decile, in terms of high yield, produced an
average annualized return over 34 years of 19.3% versus 13.0% for the Financial Times Actuaries All
Share Index."

Not too interested in the specifics of the article. Though even at a cursory glance it represents the top down logic of academics and economists, who squeeze reality to fit the way they have framed an issue, as opposed to changing their frame to fit reality. These same people will tell you that Warren Buffet is just lucky: that it is impossible to beat the market consistently no matter how hard you research, and that share prices follow a random walk.

Importantly, I agree with ChristopheBassons: not only are managers poor allocators of capital, they are often hopeless alocators of capital.

Though I have no data at hand, I beleive it is well known that the dividend payout ratios of privatley owned companies far exceed those of listed companies. In fact, if you study the cashflows of major blue and mid caps, you will find companies with owner earnings sufficient to easily support yeilds of 10% after capital expenditure and retentions for cyclical downturns.

There is also a cultural explanation: we have come to accept 3% dividends on companies generating 20% ROE and willingly allow them to go empire building at our expense. As an aside, any large cap that goes on a buying spree is admitting that it can no longer generate a high enougth return through its own operations. How much less the waste in capital if all such imperialists simply returned the cash to their shareholders and let them decide what to do with it.

It is also interesting that in say Dubai, where shareholders are known to forcefully harrang management at AGMs about dividends, there are much higher payouts: their market average yeild is 9%! Obviously, double taxation on dividend income doesn't help - how criminal that profits that have already had corporation tax deducted must then be subjected to taxation at the personal level!!!!!!!!!!! Trully criminal!!!!!!!!!!!

As a contemporary example, consider EasyJet: its managers speak the language of growth, 'we have the biggest route network in Europe' they say. So important is growth, that they will commence low margin routes just to improve their growth figures. Their famous, vocal and largest stake holder (though unfortunately for him not controlling) understandably has very different priorities.

As a counterexample Ryan Air - where management own 10% of the company - has just paid a whopping 10% one-off dividend and looks likely to offer simmilar large cash returns in future. Good capital allocators? Hell no, nobody throws their own money way do they?

Buy a company with one dominant shareholder and you will almost certainly get screwed . Buy into a company with a dominant but not controlling stakeholder and you can be certain they won't  be complacent about how their precious cash gets spent.

Whilst I accept that the aims of equity income funds might lead to some confusion, I don't agree with some of the points made in the article.

Firstly, there is the assumption that the market is close to being 100% efficient at least over the long term. On the other hand numerous studies have shown that the total return on a sufficiently large portfolio of high yielding stocks tends to beat the market by a significant margin over the long run. Perhaps those studies produced freak results, perhaps not, no one can say for sure. But there are good reasons why it might be true, and some of those were covered by another poster above. Its just a form a value investing after all. Certainly those results cannot just be ignored.

Secondly, even if you accept that the market is more or less efficient, an equity income fund could plausibly offer an above market yield plus at least some capital growth. The total return might end up being less than the whole market, but then that wasn't what was promised. An investor might even be happier with that result if the volatility of returns is lower.

Surely the stock price going up the next day relative to the market is irrelevant to it's contribution to total market dividends, so why would you trim it?

To keep the fund in line with the model and manage risk.

If the model says hold 7% of HSBC (LON:HSBA) then the fund should hold that amount all the time. Not just when you construct it.

Otherwise you get unbalanced and risk a bigger loss if the stock suddenly corrects.

Surely the stock price going up the next day relative to the market is irrelevant to it's contribution to total market dividends, so why would you trim it?

'm afraid that your clarification about HSBC and the amount they will pay out leaves me just as confused. Are you saying that you select stocks on the basis of total dividends paid without consideration of market cap, number of shares in issue or share price? On that basis you will always pick HSBC, BP etc simply because they are vast, so in reality all you would be doing is selecting the largest mcap stocks in the index, provided they pay out at least something in dividends. It may work, but the rationale is not clear.

No, you are not confused, that is exactly what we do. We ignore valuations to construct the model and then populate the fund according to the model.

So if 7% of the income of the market comes from Vodafone Group (LON:VOD) the fund puts 7% into it regardless of price. If the stock goes up the next day, and the market doesn't so its position rises to 7.5% we trim it back and lock in the gain.

So, yes the fund is overweight the megacaps.

Perhaps this will help.

HSBC is forecast to pay out £5 billion in dividends next year making it the largest dividend payer in the UK market.

However, its current yield of 3.2% is nowhere near the the highest yielding stock in the FTSE 350.

Does that make sense?

The rationale of the fund I run is based around dividend income, not yield.

Taking share price out of the construction process gives a very different picture of the market.

The highest yielding share is not the same company that pays out the most in dividends.

Sorry, most of this is pure conjecture without any basis in reality. This is the crux of the issue:

"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."

When I hear "corpus of knowledge" and "regarded [by the market]" I think straight away herding and under/overshooting. Yes, a numberof poor companies with unsustainable payouts will have (justifiable) high yields. The key question is, however, in aggregate will market opinion on those companies be likely to be wrong or right? The likelihood is that the market will tend to be overly pessimistic and overpay for the good prospsects.

Couple this to a number of sound reasons why dividend payers might be fundamentally better investments: dividend payment forces a sharp focus on positive cashflow; managers are poor allocators of capital, because they're incentivised by things other than pursuit of profit; non-profitable/non-cash-generative companies are filtered out.

It's been a while since I read the book, but what about Dreman's studies?

McEssex, have I got confused by something too? Aren't you involved in a high-income fund? Aren't you undermining the own investment rationale behind that fund?