7 February 2018

Eight reasons to avoid equity income funds for income

Many investors (and financial advisers) rely on equity income funds to provide income. They are funds which invest in companies paying dividends, and those dividends are paid out as income, preserving - the theory goes - the capital value. But the approach is not without its problems and it is not one that I generally take with my clients. Because ...
  • Dividend payments are not regular. Some pay quarterly, some half-yearly, etc.. That leads to an uneven income for investors - good if that is a significant part of your income.
  • Dividend amounts are not regular either. It's like an employer paying different amounts every month if it is your main income.
  • Income cannot readily be changed. When circumstances change and additional income is needed, a dividend strategy cannot deliver. 
  • Whenever a fund manager has to restrict the companies they can hold in their fund - such as to those that pay dividends - they are likely to restrict their performance. The data bears that out with Citywire reporting lower returns for UK equity income funds over three years than for the UK All Companies sector (admittedly using average performance in each sector).
  • Dividend-paying companies are mostly UK-based. While the rest of the world is catching up to some extent, having to bias your portfolio to one investment sector is a risky approach.
  • Taking income from dividends doesn't guarantee that the capital value will not fall, any more than it does with a growth-oriented fund.
  • Companies sometimes have to skew their financial situation in order to pay dividends. Companies with pension deficits are sooner or later going to have to prioritise that rather than paying dividends. And that is particularly difficult if you have a history of paying rising dividends. Think Carillion for a recent example.
  • The tax situation could go either way depending on investor circumstances. There is a small dividend allowance, but for many investors, using their Capital Gains Tax exemption is going to be more effective. If funds are held in in ISA then tax doesn't apply anyway.
So what is the alternative? A strategy to sell from a broadly-based portfolio to provide “income”  in the form of regular withdrawals is generally preferable in my view. Either by selling across all funds or by defining a single low-volatility fund to make regular sales from, and then topping that up from the growth part of the portfolio on an annual basis, for example

Blog Archive