Two fund plays on an unloved but outperforming market

The UK equity market is currently having its fifth best year-to-date return in 30 years, with the FTSE All-Share index having returned 16.5% to the end of September 2025, once dividends are included.

This is second only to emerging markets on a local currency basis, which are having a stellar year in their own right.

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The strongest returns have come from the two defence heavyweights, Rolls-Royce Holdings (LSE:RR.) and BAE Systems (LSE:BA.), which, along with their European peers, have rallied off the back of massive pledges by European governments to increase their respective defence spending.

UK banks have also achieved strong share price gains due to solid profitability in a favourable interest rate environment.

Despite this, flows from UK equity funds and exchange-traded funds (ETFs) have remained negative so far in 2025, with more than £20 billion of net redemptions to the end of August – the largest of any equity category. This equates to nearly 9% of assets from the start of the year. In fact, UK-focused funds have been the least favoured equity sector in all but two of the last 51 months.

Perhaps this reflects investors’ wariness amid the constant headlines regarding the government’s fiscal constraints, but there remain reasons to stay optimistic on UK equities into 2026.

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First, despite valuations rising from their unprecedentedly low levels this year, the forward price/earnings (PE) ratio remains below the long-term average at 12.9x and is still cheap relative to the other main equity regions.

Second, some commentators including Morningstar Investment Management Europe believe the macroeconomic perspective in the UK is actually in reasonable shape, with GDP growth forecasts pointing to an incremental improvement on 2024 along with high household savings and rising real wages. Still, one could argue that, with around 80% of company revenues coming from overseas, the macro picture is less relevant for the bulk of UK equities.

Third, the “cash-yield” on offer from UK equities, which includes both dividends and share buybacks, stands at over 5% and continues to be a compelling proposition versus other regions, and compares favourably to bank rates, government bonds and inflation.

Dividends have proved a very powerful force in investment, with both the initial yield and yield growth being crucial factors in investors’ long-term returns from stocks.

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A study from Allianz Global Investors shows that over the past 40 years dividends accounted for almost 39% of the annualised total return for European equities (with an even higher proportion for just UK equities), which contrasts to just a 22% contribution from US equities.

The study also shows that dividends themselves exhibit less volatility than corporate earnings and that equities from dividend payers have proven to be less prone to volatility in the past than equities from non-payers.

So, with rate cuts that started in 2024 and are anticipated to continue into 2026, income investors seeking a reliable yield should consider UK equities.

Ways to play the UK

One of the funds to highlight from the interactive investor Super 60 investment ideas list is Artemis Income, which has a Morningstar Medalist Rating of Silver.

The fund has been managed by Adrian Frost since 2002 and is co-managed along with Nick Shenton (from mid-2014) and Andy Marsh (from February 2018). They primarily hunt for companies with attractive cash flow yields with the goal of constructing a portfolio that generates cash flow more than the market.

The managers take a core-like approach to portfolio construction, aiming to maintain a good level of diversification regarding cash flow and dividend streams. On the theme of capital returns, over the 12 months to April 2025, 70% of the companies in the Artemis Income fund have bought back shares, a signal that companies believe their shares to be undervalued.

Returns for the fund are among the best in the UK Equity Income category over 10 years, with a dividend yield 20% greater than the index on average.

A second investment idea from the ii Super 60 is City of London Ord (LSE:CTY) investment trust, which has a Morningstar Medalist Rating of Silver.

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The trust, managed by Janus Henderson Investors, has seen manager Job Curtis run this strategy since 1991, with David Smith earmarked as his successor having co-managed since July 2021. 

Curtis is a cautious, mildly contrarian investor. A company’s cash generation and physical assets are important in his analysis, but the primary focus is dividend yield as a measure of value, together with balance-sheet scrutiny to ensure robustness, continuity, and growth in distributions.

Closed-ended vehicles, such as this, have benefits over open-ended vehicles, including the ability to use leverage, share buybacks, and revenue reserves. The last point is particularly important for income strategies, as it allows the manager to hold back income in good years and use it to support dividend in tougher ones. This “smoothing” mechanism helps investment trusts keep dividends steady, such that this strategy has grown its dividend for 59 consecutive years.

Returns for the trust are also among the best in the UK Equity Income category over 10 years, with a dividend yield over 40% greater than the index on average.

Andrew Jayne is associate director for manager selection at Morningstar.