For the avid readers of our blog, it probably won’t come as a surprise that we don’t like so called 'equity income funds'. Don’t get us wrong, we like high quality stocks that pay dividends just as much as anyone. The issue for us is simply, that we don’t like to take capital risk when looking for income. And there is a lot of risk of losing money in any form of equity ownership. If the markets are down 50% for instance, then your equity income fund will also be down 50%, more or less. And at that point, we don’t really care that we are getting a 4% dividend because, you know, we lost half of our money.
But let’s look at the mechanics of dividends in a bit more detail to reinforce our point that you should never buy equities to generate income. A dividend that is paid out, reduces the value of the company by the exact amount of the dividend, e.g. if the share is trading at £100 and pays out a £5 dividend, then the share is worth £95 after the ex-dividend date. That’s not income, it is a redemption of capital. By that same token, we could buy a hedge fund and redeem 5% every year. Yes, we would get 5% back, but it ain’t income.
Most equity income funds also charge very high fees. The reasoning being that you have to pick your equities that pay dividends very carefully, entailing research and in-depth analysis. But if the argument can be made that you can’t pick stocks, because you can’t beat the market, then why should those same people be any better at picking stocks that pay dividends? All statistical evidence confirms that active management doesn’t work, which would also explain why the passive management behemoths of Blackrock, State Street and Vanguard now have more than USD 10 trillion in assets under management.
But the biggest argument as to why not to do it can simply be found in the empirical evidence. And so, we took a look at one of the most famous UK fund managers whose superstar status has enabled him to manage more than £8bn in assets in his equity income fund. His fund’s dividend yield is 3.6%, whereas the dividend yield of the FTSE 100 is 3.85%. The fees however at 1% were a lot higher than the 0.1% you pay for a passive FTSE 100 Index fund. And wouldn’t you know it, the equity income fund has underperformed the FTSE 100 since inception by, you guessed it, about 1% per year. You can’t make this stuff up.
If you need income, do yourself a favour and don’t buy the hype, there is no free lunch and getting income from taking market risk is not a good idea. If you genuinely want income, then the best way is to get exposure to credit risk. That is, where you're lending someone your money and you can expect to receive a fixed payment of interest or a coupon until your money is paid back. And very importantly, where your capital is protected through some sort of security, be it a government guarantee or other forms of collateral. The private lending markets in particular have been generating very attractive and consistent yields, in an environment where capital is seemingly still not deployed efficiently.