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UK equity income versus the IFL portfolio

UK equity income versus the IFL portfolio

UK equity income funds are consistently one of the biggest selling group of funds in the UK. This is because most people investing capital are entering retirement and need income. If you are investing for a typical retirement timescale of 25 years – though the actuaries say it may well be 35 years – you must invest a substantial proportion of your capital in equities. Only they can generate an income that rises in line with, or at a faster rate than, inflation.

In theory, you could invest in growth-oriented funds and strip capital out for your income needs. But this is risky. If the markets fall and you keep drawing “income”, you will suffer from “pound-cost ravaging”, eroding your capital to the point where it is virtually impossible to recover. If you have never done this, it is worth testing the proposition with a pocket calculator. Start with £100,000 invested and take a 5% income when the investments are paying out 2%. You are consuming 3% of your capital each year. The market plunges, your capital is now worth £70,000; you draw not 3% of your initial capital to get your required top-up of £3,000, but 4.3% of its current value. That reduces your capital further; now, what if the market falls again? It does not take 25 years to reach Doomsday.

Keep it natural

Whether they get the maths or not, most investors are aware of the risk and try to rely on natural income. And because they avoid currency risk, UK equity income funds are a natural choice – though, as I have argued previously (Issue 353), global equity income funds are in many ways a better proposition.

There are scores of UK equity income funds with historic records ranging from the spectacularly good to the dismally poor. Most analysts focus on the total return to investors, and while this can identify managers who are good at picking stocks, that does not always equate to funds that generate steadily rising income.

Are such funds a good alternative to Douglas Moffitt’s Income For Life portfolio or the RIRP? I will offer a tentative answer.

Drill into fund data

First, I will assume that you can pick the better UK equity income funds. Thanks to the many “buy lists” published by Hargreaves Lansdown, Bestinvest and others, you can easily get the selections of analysts who have crunched a lot of numbers. They may not pick the best but they will certainly avoid the worst and the mediocre.

I am not going to compare lists, but the four funds I am going to focus on do in fact appear on a lot of buy lists. Table 1 lists four funds, three of which have caned the sector average performance over 5 and 10 years. Chart 1 shows how three of them have performed over the 11 years to June 2015. They have generated total returns of between 200% and 275%, equivalent to between 10% and 12% annually.

Chart 1

UK equity income
Key :•A Unicorn UK•B Invesco Perpetual•C Threadneedle UK•D UT UK Equity

Chart 2 takes one of these funds and shows the difference between the total return, where net income is reinvested in additional units, and price, where the investor takes and spends the income. The investor who reinvested income achieves a 20-year return of 800%, while the income taker gets 400%.

Chart 2

UK equity income
Key :•A Invesco Perpetual – Income Inc TR•B Invesco Perpetual – Income Inc

Chart 3 then takes this same fund, Invesco Perpetual Income, and looks at the actual income earned on an initial investment of £10,000 over the same 20-year period. After 13 years the total income earned exceeded the initial investment. As of now, it is more than double the initial investment. Most investors would, I think, be extremely happy with this outcome. In fact, many of them were so happy that when the fund manager, Neil Woodford, left IP to set up his own fund, almost £5bn left IP to follow him to Woodford UK Equity Income. As Table 1 shows, Woodford has started well, with returns well in excess of the sector average for the first year.

Chart 3

UK equity income
Key :•A Invesco Perpetual – Income Inc Net income earned on initial £10,000 investment

For many years Woodford’s returns were head and shoulders above the rest of the sector, but there are now several others with almost as good total returns – though few with his consistency in steady income increases.

Woodford’s style is to make large investments in sectors and companies. Most notably, he took huge positions in tobacco stocks in the 90s and is currently a large holder of Big Pharma shares like GSK. But, at the same time he also allocates up to 10% of his portfolio to start-ups – unlisted companies, often in sectors like biotech, and often university spin-outs.

Given Woodford’s long record, and despite the handicap of a near-£6bn fund, I would expect his fund to generate well above-average returns for investors, including steady dividend increases.

Threadneedle UK Equity Income is one of the best of the traditional funds, with capital almost equally spread between mega cap (£50bn plus), large cap and mid cap stocks. The managers here are cautious types and worry a lot about possible dividend cuts. They note that dividend increases have been greater than profit increases; the UK payout ratio has risen steadily in recent years so the average dividend cover is about 1.8X. This portfolio contains no bank shares as the managers expect returns from “safe” banks to decline sharply and do not wish to own shares in speculative banks.

Possible boost from small-caps

The extraordinarily high returns from Unicorn Income are, in my view, a predictable consequence of the higher long-term returns earned by small-cap shares, as evidenced by many academic studies. Dig into this fund’s history and you will find it is far more volatile than other equity income funds, nor is its income payment record so steady. Unicorn specialise in managing small-cap portfolios, an area where you can still secure good returns on legwork – meeting business owners and managers – and analysis. You might want to combine a holding in this fund with one of the other two.

Now for the major handicap of all these funds. The yields shown are misleading. Every one of them takes its management fees from the capital of the fund. Average management charges and costs are 0.8% of assets, so the actual yield you can take as natural income is in every case 0.8% lower than the yield figure shown in the table.

Taking that into account, the initial yield of the Income For Life portfolio is significantly higher. Because the IFL will hold many fewer stocks than the funds, which typically own 50-100 shares, its capital volatility and the risk to income from disasters, will be higher. Will the IFL generate larger income increases than Woodford or Unicorn? Over the long term (over 5 years), I doubt it – but because the initial income from IFL is significantly higher, the funds will have to grow their income at quite a lick for their total income to exceed the IFL’s.

Of course, the big difference is that the funds require you to do no work at all, nor deal with problematic decisions of the type that Douglas Moffitt has regularly faced with the RIRP. And if you run your own IFL portfolio you must manage it and make those decisions – it cannot be a “buy and forget” investment.

So my conclusion is that for active investors prepared to put time and effort into managing their capital, the IFL is likely to generate higher income than UK equity income funds for the first 5 years and possibly longer. The IFL’s capital value will certainly be more volatile, though if you follow Douglas’s methods you will ignore this except when forced to take action by the system rules – which I have asked him to spell out in more detail in his next article. And, on the other hand, if you do not want to be an active investor, then pick one or more of the funds I have featured, draw 0.8% annually less than the declared yield, and expect an inflation-beating income for as many years as you have left.

Chris Gilchrist, July 2015

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