Five tips to pick the right equity income funds

What you’ll learn:

• What to look for when choosing equity income funds.
• Why diversification matters.
• How re-investing dividends can boost the value of your savings.

It’s tougher than ever to find decent returns from cash savings or assets such as bonds. For investors willing to accept a much higher risk of losses, equity income funds can offer attractive yields, as well as scope for capital appreciation if the stock market rises.

These funds have seen significant inflows of money in recent months, according to the Investment Association.¹ But while equity income funds are certainly worth considering for income seekers, it’s important to tread carefully.

Like any other investment, equity income funds can fall in value as well as rise and you may get back less than you invested. Also remember that the income you receive from these funds can vary over time, and probably will.

Here are some suggestions to help you pick the right equity income fund for your portfolio.

Don’t be too dependent on a small number of shares

Take a look at the underlying investments in your equity income funds and consider how much exposure you have to individual companies. You might find that different equity income funds hold a similar group of shares.

The FTSE 100 Index of Britain’s biggest companies currently yields around 4%, but large chunks of that yield actually come from a relatively small group of companies, such as Royal Dutch Shell, HSBC and GlaxoSmithKline.

If one of these companies runs into trouble and is forced to cut dividends, investors can be hit hard. For example, when BP suspended its dividend in the wake of the Deepwater Horizon oil spill in 2010, investors in the FTSE 100 lost a sixth of their income at a stroke.

The index is also heavily weighted towards certain sectors – notably mining and financials. If one of these industries runs into difficulties and several companies have to cut dividends, the effect may also be pernicious.

It’s therefore crucial to make sure you’re not relying on a small number of blue-chip companies for dividends.

You may think you’ve reduced your risk by diversifying your investments across a number of different equity income funds. However, if the funds all have similar underlying investments, you may still be dependent on the same small number of shares to provide all your dividend payments.

Instead, look at ways of diversifying the income you receive, by picking out funds from different sectors or regions.

Look beyond the FTSE 100

Don’t assume small and medium-sized companies aren’t capable of paying attractive dividends; many have an excellent track record of paying decent incomes.

The FTSE 250 Index covers the 101st to the 350th biggest firms on the stock market and contains medium-sized companies – mid-caps – with a more domestic focus. It currently yields 2.6%, which is still more generous than what’s on offer from many corporate bonds; anyway, it’s an average – many constituents yield much more.

Moreover, small and medium-sized companies have the potential to grow faster and further than larger firms, providing the potential benefit of capital growth as well as income. However, this isn’t guaranteed and there is also the potential for greater volatility and falls in value. Like any investment, shares in small and medium-sized companies can fall as well as rise. Remember that you may get back less than you invested.

Don’t just stick with the UK

UK companies aren’t the only businesses that pay dividends. As your portfolio grows in size, it might make sense to add international equities. This is partly because of the generous yields on offer in other markets and because overseas markets may also deliver good capital returns. Investing overseas also helps to protect you from the ups and downs of the UK through diversification.

Consider global equity income funds, which offer exposure to a broad spread of international equities, with a bias towards high-yielding shares.

However, remember that investing in assets listed overseas may expose you to the additional risk of foreign exchange rate fluctuations, as well as the performance of the underlying asset. If you hold investments that are valued in other currencies, any fall in the value of those currencies compared to the pound would cause a loss in sterling terms, while a rise would produce a sterling gain.

Re-invest dividends, if you can

Income seekers may need to draw down a substantial chunk of the dividend income they earn, but if you can reinvest some or all of these pay-outs, the long-term effect might be a boost the value of your savings.

In fact, reinvesting your dividends could have a dramatic effect on the value of your investments. Barclays’ Equity Gilt Study is an annual report that maps asset class returns all the way back to 1899. It shows that £100 in today’s money invested in equities – represented by the Barclays UK Equity index – that year would have been worth only £177 by the end of 2015 in ‘real’ terms, adjusted for inflation, if dividends had not been reinvested.²

The same £100, but with dividends re-invested, would have grown to £28,232 in ‘real’ terms over the same period.

Figures reflect price movements without dividends reinvested. Past performance is not a guide to future performance.

Source: Barclays

Stick with funds

More experienced investors may decide to build a portfolio of dividend-paying shares themselves. However, holding individual shares presents a much higher risk of losses compared to using funds, which help to diversify your investments, reducing the impact if shares in one company performs badly.

What’s more, dividend trends evolve over time. If you’re not able to stay abreast of these developments, or don’t feel comfortable making investment decisions on your own, you should consider using an actively managed fund. That way, a fund manager and their team of analysts can monitor the equity income sector on your behalf, with the aim of achieving consistent returns over time.

For example, for many years, natural resources companies were generous dividend payers, but as commodity prices have plunged more recently, many have been forced to cut their dividends. It might once have made sense for income seekers to have been over-exposed to this sector, but not any longer.

Similarly, Japanese companies have never had much of a dividend culture. But following a prolonged period of shareholder activism, which has seen investors pressure many companies to change tack, Japanese dividends have begun rising.

Please bear in mind that this article is for general information purposes only. If you are not sure which investments to choose or how to manage your investments, seek professional independent advice.