Why UK equity income fund investors are in a dangerous place

Fund manager Robin Geffen warns that UK equity income funds are burning capital in their pursuit of yields. 

Those who rely on income-paying stocks face a number of dangers, fund manager Robin Geffen has warned.

Geffen, who sold Neptune Investment Management to Liontrust (LSE:LIO) at the end of July, points out that there is a dangerous amount of concentration among UK income-paying stocks, with just 10 stocks accounting for 50% of the FTSE All Share index’s yield.

“The payout ratio is the highest I can remember in my lifetime,” said Geffen, who manages the Liontrust Income fund.

And a high proportion of dividends, he warns, are also not sustainable. He notes the 10 largest contributors to the index’s yield have an average dividend cover of 1.1x.

As a rule of thumb, a low dividend cover score – of around one times or lower – suggests that dividends are vulnerable, as the company is using most, if not all, of its profits to fund its dividends. A figure of two or more times is viewed as comfortable because it is a sign that a business is not over-distributing.

Geffen notes that UK company earnings are slowing, meaning those dividend covers are likely to go even lower. “Big companies you thought you could rely on will be cutting their dividends,” he argues.

Geffen, however, warned that many UK equity income funds are exposed to these risks. He argues various funds in the sector are placing a greater emphasis on generating a high yield at the expense of delivering sustainable income streams. Chasing yield in this way, he warns, has become increasingly dangerous.

Geffen gave the example of fund managers holding Imperial Brands to boost the yield of their fund. He notes while the company increased its yield by 60% over the past 12 months, this had come at the expense of falling share prices. “Buying that dividend cost you 30% of your capital,” he said.

Added to that, he points out the company is already warning that it won’t be able to maintain its current dividend growth rate of 10%.

He points out that if investors bought the stock in mid-September, thinking its then yield of 8.7% was attractive, they would have now lost 19.8% in capital terms. The company’s dividend cover, he pointed out, is less than 1.

Yet, says Geffen, the UK equity income sector is very reliant on this stock for yield, with 70% of UK Equity Income funds holding it. “It is very easy to chase yield and burn capital,” he says.  

He points out that currently it generates 4.8% of the sector’s yield and 2% of the FTSE All Share’s yield.

“This is just not sustainable.”

Geffen adds:

“Chasing yield like this is increasingly dangerous. You may think you have seen bad things in the UK income market, but you ain’t seen nothing yet.”

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