Two low-cost UK funds for income investors

Finding a mix of high yield and quality has become increasingly difficult, but Dzmitry Lipski has identified a pair of low-cost income funds with sustainable growing dividends.

A challenging environment for income investors over the last several years is forcing them to look at various ways to squeeze higher yield out of financial markets.

As we move into an environment of monetary tightening, investors worry that this could cause bond prices, and possibly high-yielding equities, to fall in value when rates to return to more normal levels.

Despite this, there are significant opportunities to earn higher income from equities, not only through 'actively' managed strategies, but also through 'passive' low-cost investments such as index trackers or exchange traded funds (ETFs).

• Income investing: Helping you find high yields
• For more income fund ideas check out our new Super 60 selections

Companies in the UK have a long-established track record of paying dividends. According to the latest UK Dividend Monitor from Link Asset Services, UK dividends for 2018 could reach a record breaking level of £99.5 billion, thanks to returning strength in banking and mining sectors and weaker sterling. Despite the uncertainty that Brexit negotiations bring, the outlook for dividends looks more solid than one might imagine. 

Investors are still concerned that, while the headline number continues to grow, the sustainability of UK dividends has been questioned. The current FTSE 100 dividend yield is above 4.3%, which is still very attractive to a gilt yield of 1.4%.

However, UK dividend cover is below the safe 2x mark, and 34% of all UK dividends in Q3 this year were paid by just five companies: HSBC, Shell, Vodafone, BP and Rio Tinto.

There are a number of low-cost funds for investors looking to gain exposure to high-dividend-paying UK equities.

The iShares UK Dividend ETF is among the largest from the low cost offerings. 

The fund tracks the FTSE UK Dividend Plus index, which includes the 50 highest-yielding companies in the FTSE 350 Index, with weightings based on their one-year forecast for dividend yields. While it looks like one of the simplest approaches to constructing an index of dividend stocks with high dividend yield, (currently 6%), it has limitations and risks attached.

Every investor knows that simply selecting the highest yielding stocks can be a risky strategy, as some may be companies with poor fundamentals whose stock is trading at low prices to reflect the fact that they may be in trouble. By ignoring stocks fundamentals, the fund exposes investors to so called ‘dividend traps’, a situation where a stocks expected dividend yield is too attractive to be sustainable.

Although the fund has delivered above-average performance over recent years, during the financial crisis in 2008 it lost almost half of its value due to its heavy exposure to 'dividends traps' in the European banking sector.

'Dividends traps' are not uncommon in current markets as well. Over the last few years, the search for yield in the low interest rate environment has led to an increase in demand for high-yielding growth equities.

As a result, companies are tempted to pay unsustainably high dividends, sometimes through debt, to attract investors. However, after strong performance, valuations in these areas are looking stretched, making them vulnerable to expected interest rate rises.

That's why at interactive investor we focus on selecting funds for income seekers that invest in high-quality companies with sustainable growing dividends rather than companies with just high payouts.

The SPDR S&P UK Dividend Aristocrats ETF has been picked by us as a low-cost income option for investors. 

The fund tracks the S&P UK High Yield Dividend Aristocrats Index, made up of the 30 highest dividend paying UK companies, with a track record of maintaining or growing dividends for at least 10 consecutive years. 

However, this year the dividend payout history has been reduced from 10 years to seven years, with the number of stocks increased from 30 to 40 to ensure the strategy remains diversified. The revised methodology ensures that companies that have omitted dividends are removed more promptly from the index, while the quality level of the companies selected for the index is maintained.

In terms of current positioning, the largest sector exposure is to financials at 23%, followed by consumer discretionary 22% and staples at 12%. Among, its top holdings are: BT (6.1%), Marks & Spencer (4.8%) and Imperial Brands (4.2%).

The fund had a tough time this year due to an indexing error made by S&P Dow Jones after it failed to remove Carillion from the index in time. The fund's more defensive quality bias in stock selection also dragged on performance but should help to outperform during market downturns.

Going forward, recent changes to the fund methodology, a clear focus on high quality sustainable yield and competitive fees, should benefit income investors over the longer term.

The fund has relatively narrow focus with only 40 stocks in the portfolio, making it still a risky strategy for some income investors. 

Instead, they could consider Vanguard FTSE UK Equity Income Index Fund to gain a broader income exposure to the UK market. 
The fund, part of interactive investor's new Super 60 fund selection, tracks the FTSE UK Equity Income Index of the 130 highest dividend paying shares, spread across various sectors bringing benefits of diversification to investors.

Source: Morningstar Direct as at 31st October 2018

For more income fund ideas check out our new Super 60 selections which covers a range of asset classes and geographies, to help you add some diversification to your portfolio or indeed to start building your own income portfolio.