Why the Investment Association's definition of the Equity Income sector will leave funds sailing towards dangerous waters

Carl Stick
Boat People
Another fund has fallen out of the IA's Equity Income sector recently... (Source: Getty)

Over the last few years, the FTSE All Share’s running yield has been widely discussed. The subject is important because the major qualification for existing within the Investment Association (IA) Equity Income sector is the provision of an income yield 10 per cent above that of the FTSE All Share, on a rolling three-year basis.

While the rules are clear, they mean tacking towards dangerous waters, as far as portfolio risk is concerned – something we’ve avoided doing just to satisfy these criteria.

Unsurprisingly, the Rathbone Income Fund no longer qualifies for the aforementioned sector…

Our fund’s foundation stone is the provision of a growing income stream. Essentially, if we can invest in businesses which can sustain organic earnings growth, financed by internally-generated cash flow, and this translates into dividend growth, then we’re well placed to pay out a progressive income stream.

If a fund can maintain real growth in distributions by investing in the right sort of businesses, without resorting to shenanigans such as derivative trading (outside of our skill-set), stock-lending (philosophically ill-suited), and trading around ex-dividend dates (we are long-term investors), then the unit price should also look after itself.

Yield is relevant, but it’s the growth in dividend that generates real returns.

On the sector’s yield requirements, Societe Generale’s Andrew Lapthorne highlights that the investment pool is shrinking – fewer than 25 per cent of UK companies yield more than the 110 per cent threshold. But of greater concern to income investors is that scrabbling around after yield often forces funds to chase “bad” dividends. Businesses trading on high yields tend to cut their pay-outs.

We agree with Mr Lapthorne’s conclusion, which is to focus on a business’ free cash flow and its ability to re-invest this cash, at attractive levels of return, into the business, rather than being motivated by a requirement to pay out unrealistic and, ultimately, illogical levels of dividend.

So do investors want us to trust all the yields on offer at the top of the FTSE? Or should we place a greater emphasis on growth and sustainability?

For us the answer is clear, and the investment rationale is sensible, so long as we remain cognisant of the price that we’re paying for this sustainability.

That is what active managers are paid to do. We’re not being paid to follow the market blindly, in order to fulfill an arbitrary target, and thereby expose our investors to unnecessary risks. We make no judgement as to what the FTSE All Share may yield in 12 months’ time, but we can determine the absolute level of our distribution.

The Rathbone Income Fund has a very strong dividend record. Our sector may change, but the defined process and philosophy that drives the fund should not.

Related articles