Are equity income funds worth the hype?
Equity income funds may not live up to their hype, writes Morningstar's Kathryn Young.
Financial advisers constructing and managing income-focused portfolios continue to face the challenge of low yields from cash and fixed interest.
Because of this, share managed funds with an income focus have come to the fore. These are not an entirely new innovation, of course – a number of share funds focused on high-yielding companies paying fully-franked dividends have existed for years.
But more of the so-called equity income funds have come to market over the last two years, many of which use derivatives to juice up their income generation.
Given the already dividend-rich nature of the Australian sharemarket, however, advisers would be right to be sceptical about the value proposition of this new generation of equity income funds.
The following analysis therefore compares the characteristics of these equity income funds with other options for sharemarket exposure.
Income
Figure 1 shows the average income distributions over the one, two, three, and five years to 31 July 2013 paid out by the average large-cap Australian share fund, the average equity income fund, the average derivative income fund, and the sharemarket (as represented by the Vanguard Australian Shares Index Fund).
Derivative strategies have clearly paid out the highest income distributions, while the equity-only strategies’ income payments have only outpaced the average large-cap Australian share fund by a slim margin.
These figures can include capital gains, but do not include the impact of franking credits. Capital gains should not meaningfully skew the relative analysis, but if imputation credits were included, they would be likely to favour the equity-only strategies, inflating their returns relative to the others.
It’s unlikely, however, that the impact would change the comparison substantially, because all the types of funds considered here would get some benefit.
Regardless, the pattern demonstrated can reasonably be expected to hold up in the future, because the time periods under study include a variety of beneficial and adverse conditions for all these types of share funds.
Capital growth
It’s not a good idea to consider income in isolation, though, especially given that investors look primarily to equities for capital growth.
Figure 2 shows price returns for our fund groups, which only measure the returns generated by the price movements of the stocks held in the portfolios.
The graph clearly demonstrates that the superior income generated by the derivative income strategies is no giveaway.
They exhibit lower capital growth over time because the options they sell to generate income typically require them to sell stocks in the portfolio as their prices rise. (These funds typically use covered calls, which involve writing a call option which gives the purchaser the right to buy the stock at the exercise price, which the purchaser will do as the stock’s price rises past the exercise price.)
That means the funds miss out on some of the gains during market rallies.
Figure 2 shows that equity income funds have generally outpaced more traditional share funds over the past three years or so, as the market’s general search for yield has benefitted funds holding the most dividend-rich stocks.
However, the capital growth generated by all these groups converges over longer periods, suggesting that the recent dominance of income stocks is a cyclical phenomenon. Advisers should not therefore assume that high-yielding stocks are inherently superior.
Risk
It’s also a bad idea to consider returns in isolation. Advisers should equally consider a fund’s risk profile and the extent to which it matches that of their client.
And contrary to what might be expected, the various fund groups can have meaningfully different risk profiles. In particular, as Figure 3 highlights, derivative income strategies show lower volatility and better bear market performance than diversified equity funds.
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A record stretching back seven or 10 years would facilitate a more robust estimation of how these strategies might behave over a full market cycle.
However, the past five years have included bull markets, bear markets, and all kinds of volatility in between, so it’s fair to say that all these strategies end up at about the same place, even if they take different routes to get there.
That makes sense after looking at the component parts of the return. The equity income and traditional funds generated similar income and price returns, so their total returns should be in the same vicinity.
The derivative income strategies appeared to basically trade income return for price return. Additionally, these strategies are all ultimately exposed to the same high-level risk source – the local sharemarket – so it’s reasonable to think they would have broadly similar returns.
The overall implication is that while either sort of equity income fund may offer relatively attractive risk-adjusted returns, they’re more similar to traditional large-cap Australian share funds than they are different.
Given that domestic shares (either directly or through managed funds) account for substantial proportions of Australian investors’ portfolios, any use of equity income funds in investors’ portfolios should be considered with care.
That’s not to say that the equity income strategies may not have some utility. They could play a role in a well-diversified portfolio, especially given that there are some capable portfolio managers running these funds.
The equity-only or derivative income strategies could, for instance, be used in a supporting capacity for relatively defensive equities exposure. But there are other ways to get such exposure which many investors may already hold, including listed property and infrastructure.
The exception would be for those investors who will actually cash out the income distributions, rather than reinvest them. People actually living on the income have reason to look at a derivative-based strategy in particular, since, as we saw, these achieve a higher proportion of return from actual distributions.
However, interested advisers should carefully consider the practical reality of such an approach, including the tax bills associated with large income payments that lack applicable franking credits.
Kathryn Young is a fund research analyst with Morningstar.
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