Has The UK Income Funds Reached The End Of The Road?

Income funds have been a staple of long-term investment portfolios for decades. Funds built around stocks that provide dividends that can be reinvested have been the backbone of the compounded returns that are such a powerful factor in accumulating wealth over decades.

But the recent past and present hasn’t been in favour of stocks and funds whose raison d'être it is to provide shareholders with a cash income that can be either reinvested or sustainably spent. The 2019 implosion of Neil Woodford’s Woodford Equity Income fund was followed by the early-June sacking of Mark Barnett, manager of the Invesco Income and High Income funds.

Having worked under Woodford at Invesco, and taken over his role as manager of the company’s income funds on his departure, taking a similar approach to his mentor, Barnett is often referred to as the former’s protégé. Both were until recently regarded as champions of small investors, with their funds consistently delivering market beating returns, and a steady stream of income.

They are now derided as responsible for underperforming for those same investors. Both have been criticised for deviating from the tried and tested formula of building portfolios around reliable if unspectacular income generators. Instead they invested significant sums in the illiquid stock of still private, or small-cap, tech and biotech start-ups.

But did the formerly heralded income fund managers lose their way after becoming arrogant and overly confident in their stock picking abilities? Or was their move into riskier waters provoked by traditional low to middle-risk profile income investment strategies having seen their day?

Was there no longer enough income being paid out by blue chips and well-established mid-caps to allow Woodford and Barnett to stick to the recipe that had previously brought them, and their investors, success?

If things were already getting tough for income investors, 2020 has been a real annus horribilis. The coronavirus crisis has meant over 40% of dividends due to be paid out have been either deferred or cancelled. The current dividends scenario is only expected worsen, with many of the companies, such as BP, who did defiantly choose to follow-through with their planned dividend payments in the second quarter, likely to succumb to the reality of reduced cashflow and make cuts later in the year.

What % Of Dividends Have Been Cancelled In 2020?

As of mid-June, a total of 42% of the dividend pay-outs scheduled for the 2020 calendar year have already been cancelled. That amounts to around £30 billion between FTSE 100 companies, with a decision still to be taken on a further £25 billion. Around £11 billion has been paid out, which is the equivalent of 17% of the dividends expected to be paid to investors over the year. Most are not overly optimistic there’s much more to come.

Dividend Yields Hit Record Highs In 2018 But Income Funds Are Underperforming

In 2018, the average UK dividend yield, calculated as pay-outs as a proportion of the share price, rose to 4.8 per cent in 2018, marking a 29-year high, according to Link Asset Services. That dipped to around 4.2% in 2019 but remained well above the 30-year average of 3.5%. The last time UK dividend yields were so high was in the midst of the 2008 recession when share prices had tanked.

However, in the midst of booming dividends, UK income funds have lost an average of 8.2% over the past 5 years. Only 18 out of 73 made money for their investors. Over the same period, a cheap global equities tracker has returned circa. 60% - over 10% per annum!

And with the largest and most reliable UK dividends traditionally coming from some of the sectors likely to be worst hit from the Covid-19 pandemic, there has to be doubt over how viable an investment strategy relying on dividends will be over future years. The oil and gas, banking, mining and construction sectors are unlikely to be cash cows over the next few years.

In 2019, 64% of UK dividends were concentrated in just 15 stocks. Of those 15, 6 have cut, cancelled or deferred dividends so far this year. The concentration of dividends in energy and finance stocks means UK income is exposed to economic turmoil that is bad for those to sectors.

Alternatives To UK Income Funds

If UK income funds look like too much of a risk over coming years, what alternatives do investors have? Especially those who would like to earn an income from their investments, either to reinvest for compounded returns or live off?

Are UK Income Investment Trusts A Better Alternative?

It might seem logical to presume that if UK income funds have underperformed so will have UK income investment trusts. But is that the case? Investment trusts are similar to unit funds, with one crucial difference – they are formed as companies and their shares trade on the stock market. This means they can use leverage, borrowed money, to invest in more shares.

This has the effect of often accelerating gains when markets are rising. On the flip side, and there is always one, the leverage investment trusts make use of, and the fact they are traded shares subject to market sentiment, has traditionally meant they suffer more during bear markets.

However, the data shows that, over the long term, investment trusts, on average, outperform unit trust equivalents. Investment trusts have another income advantage – they are permitted to hold back up to 15% of the income the generate each year in order to build up a rainy day reserve. That money can then be used to maintain income payment during lean years.

As a result, some investment trusts can boast of a record of over 50 years of uninterrupted growth in annual dividend payments.

Investment trusts originally established by wealthy families and designed to pay out income to family members often have a particularly strong record when it comes to increasing annual payments. Two examples are the Rothschild family-founded RIT Capital Partners and the Cayzer Family-linked Caledonia Investments.

However, UK income investment trusts still don’t have a great average record over the past five years, losing an average of 4.1%. While better than unit trust income investment funds, which as already mentioned have lost 8.2%, it’s still a recent history of underperformance.

Should You Go Global In The Hunt For Income?

Income investors might do well to broaden their horizons beyond UK income trusts, which only invest in London-listed companies. As already mentioned, the UK market suffers from a narrow pool of large dividend payers, concentrated in the energy and financial sectors.

Income funds restricted to UK stocks, of which there are a total of just 250, only 15 of which, as already detailed, account for a whopping 64% of all dividends paid out. Sticking to the UK also means investors miss out on dividends paid by large tech companies. For a long time big tech, such as the FAANG stocks, paid little in the way of dividends but that has changed as they have matured. Many tech companies now pay out good yields.

Internationally, across developed markets, there are around 4500 dividend-paying shares to choose from when constructing an income portfolio – either personally or as a fund manager. And they are much more conveniently spread across sectors, so risk can be better managed.

That advantage shows in the performance of global income funds, which have been far more impressive than their UK-centric equivalents. Global income unit trusts have returned an average of 26.2% over the past 5 years and global income trusts have done even better, with average returns, reaching 39.9%. The star performer of the fund category has been the Scottish American trust, which has returned a highly impressive 79.8%.

Over the same five years during which most UK income funds lost their investors money, 32 out of 34 global income funds returned the profits which add up to the average 26.2% return already detailed.

Capital Gains As An Alternative To Income?

Especially with regard to traditional UK income stocks, there is a major question mark over their long-term ability to return to sustainably attractive dividend payments post-coronavirus crisis. Traditional income favourites are often in sectors such as utilities, telecoms, finance and tobacco.

These industries are largely mature and heavily regulated with debatable, if not plain weak, long-term growth prospects. Their profits are unlikely to rise over the medium to long term.

Instead, investors could choose to focus on companies that do look capable of delivering long term income, and shorter-term capital gains. As has happened with many of the big tech companies, stocks that are on the up can often delivery strong capital gains while they growing quickly as companies. If all goes to plan, they will then transition into income stocks paying solid dividend yields as they mature.

Capital gains can also be potentially turned into income through investors selling of shares for cash when needed. There can also be tax advantages to doing so, with each individual benefiting from a £12,300 annual capital gains tax allowance (CGT).

The tax on dividends is higher than on capital gains for anyone holding investments outside of an ISA or SIPP wrapper and the tax-free dividend allowance is just £2000. Above that, dividends are taxed at the investor’s income tax band, so 7.5%, 32.5% or 38.1%. Beyond the annual allowance, CGT is 10% for basic rate income tax payers and capped at 20% for higher earners.

A good approach could be to augment traditional dividends income with capital gains income, rather than replacing it entirely. That also avoids, or reduces, the need to sell off investments for income when markets are going through a down period, such as now.

Diversify Traditional UK Income Fund Investments With A Global Outlook & Greater Emphasis On Growth Stocks

It would be dangerous to say it’s definitively the end of the road for UK income investing funds, despite the sector’s recent travails. However, with the long-term outlook of traditionally strong income stocks in sectors such as energy, commercial real estate, tobacco and banking looking unsure to bleak, the short to medium-term outlook doesn’t look rosy.

A new generation of UK income stocks may well emerge in coming years. However, it looks as though there will be a gap in the meanwhile. Income investors can compensate by moving towards global income investment unit funds and trusts to maintain dividend returns in the short to medium-term.

And growth stocks, UK or international, which look like they have strong prospects of evolving into mature income stocks, are another option. Capital gains that can be used as income while these companies are still in their high growth stage.