Income versus growth isn’t the crunch choice

 
Philip Salter
Follow Philip
MOST funds can be broadly classified as either income or growth oriented and most managers focus their abilities on one to the exclusion of the other. There is plenty of debate about which investors should favour, and although there are good reasons to lean towards one or the other, ultimately investors should focus on diversification – not classification. Not least because the holdings of income and growth funds are not as different as often presumed.

DIFFERENT STROKES
Matthew Jennings of Fidelity explains that the main difference between income and growth funds is the type of return they aim to provide to investors: “A growth fund aims for capital appreciation over time, whereas an income fund aims to deliver a steady stream of income, which can be paid out to the investors or re-invested in the fund.” As such, “growth fund managers will typically invest in companies that they believe will be able to significantly grow their earnings over time, while an income fund manager is more concerned about the level of dividend that the company pays, and the sustainability of that dividend.”

Simon Ellis of Legal & General Investments says “growth is easier to define, but harder to find. Tapping into a consistently successful fund manager in an investment area that you think shows long-term growth potential requires some diligent research, but above all you need to believe a market is going to grow.” He suggests investors without the time or inclination to try to pick the best managers should access the growth market through tracker funds, as they are much cheaper.

“Income funds work on different principles” explains Ellis, “the main principle is that by picking up dividends, coupons and interest along the way, you should be making at least a little money most of the time.” Many very large companies are paying out dividends way above commonly available deposit funds, notes Ellis. For example, Sainsbury’s currently pays out 5 per cent and GlaxoSmithKline offers 4.9 per cent.

Whether driven by animal spirits, business cycles or credit fuelled booms and busts, in theory at least, the bear and the bull tend to benefit either income or growth funds. “Growth funds usually perform well during periods of confidence in the economy, whereas income funds will perform well when investors prefer the safety and tangible nature of dividends”, explains Jennings. He adds: “The protection afforded by a regular and stable dividend payment confers a significant benefit to income funds during periods of stress in equity markets. However, when markets are optimistic, it is growth funds that will usually outperform.”

THE GLASS IS HALF SOMETHING
Investors in need of an income – principally those in retirement – are constrained by their time horizons to focus on income over growth, but for everyone else, the portfolio weighting in favour of one over the other should – it is believed – be based on a clear market view. Jennings says “over the long term it is clear that optimistic market conditions favour growth funds, while more cautious markets favour income funds.”

Foster says that “the discipline of income investing should keep investors away from bubbles, as the underlying stocks must generally be providing distributable profits in the immediate term – they are therefore less reliant on growth which may turn out to be illusory.” However, he adds: “Income investors can be lured into mistakes by the siren song of high dividend yields.” He notes that banks in 2008 were a prime example of this: “A high dividend yield can be halted, only for capital to be diluted too.” Another example Foster gives is BP, “where income funds held the stock prior to the Deepwater Horizon crisis only to sell it when the dividend was cut – in that instance the discipline of income investing meant missing out on much recovery potential.”

A BALANCED VIEW
Jason Witcombe of Evolve Financial Planning encourages investors to look at total returns. He says that what investors want is a fund that will make them money, whether that is income or growth or a mixture of the two really doesn’t matter: “No one would want a fund that produced a fantastic 8 per cent yield but lost a less than fantastic 10 per cent per annum in capital terms.”

Adrian Lowcock, senior investment adviser at Bestinvest, thinks investors shouldn’t choose one over the other: “Whether you are seeking income or growth you should have some income funds in your portfolio and vice versa.” Some funds self-define as combined income and growth funds. Lowcock thinks “these are fine if the portfolio is smaller and it is hard to get diversification, but generally speaking we prefer to separate out the two approaches to ensure the manager is focused.”

SAME DIFFERENCE
All stereotypes hide a multitude of similarities. Guy Foster, who is head of portfolio strategy at Brewin Dolphin, thinks investors should be wary of generalisations, such as the perception that “growth funds have a tendency towards volatility”. Ellis notes that “equity income funds have experienced as much volatility as growth funds over recent years.”

In fact, an analysis of the two sectors shows their performance to be highly correlated – this is because they tend to invest in similar stocks. Oliver Clarke-Williams of FE notes “the r-squared correlation between the two sectors is 0.98 over the past three years.” He also notes that of the top 10 holdings of the UK Equity Income funds, the five most popular are GlaxoSmithKline, Vodafone, Royal Dutch Shell, BP Group and BAT, appearing in the top 10 holdings of over half the funds. He adds that four of these holdings also appear in the top five of the UK All Companies sector – the only one missing is BAT, which falls to eighth and is replaced by BG Group – suggesting that the way income and growth funds invest are not substantially different.

As such, a balance of income and equity doesn’t necessarily result in a balanced portfolio. In this instance your biases might not undermine your balance. You – or your adviser – will need to get under the skin of your investments to see if you have the diversification you really want.

Whether your portfolio is diversified or weighted in favour of growth or income, Ellis says one thing is for sure: “In a high tax economy, putting money away into a tax-free Isa is almost a personal duty.”