As avid readers of this blog know, we absolutely despise so called “equity income” funds. It isn’t so much what they do, but how they are being sold to investors. With marketing headlines such as “target yields of 7% income”, you get the impression that these returns are what is to be expected. Mostly, because of the word “income”. And you really have to wonder how the FCA allows these false advertisements to persist. So, in the interest of full transparency, here are the simple facts and reasons why you should never, ever buy these products.
The definition of income, is money that you can rely on, come rain or shine. When credit agencies ask your level of income, they want to know what we have coming in for sure each month so we can pay our bills. That’s where equity income strategies completely and utterly disappoint, and that is because there is no guarantee that anything will come in. You see, it may be fine and good receiving 3% in dividends, but if the stock price is down 20%, we have still lost 17%. And before you say, well at least I received the dividend, that’s akin to burning a wad of £20,000 in cash and discovering that £3,000 didn’t turn to ash. Happy days, but it ain’t income.
The other thing that bothers me, are the fees. Active management of picking stocks with high dividends clearly needs super smart people and the gift of clairvoyance. And that doesn’t come cheap, with most of these funds charging about 1% in management fees. That is quite some difference to so-called passive index ETFs, which also pay dividends and you can buy for less than one tenth (0.10%) of the price. Given this difference in fees and setting aside the ability to predict the future, it is rather unsurprising that 99% of active managers underperform the index (Financial Times). There must surely be a reason that the passive index behemoths of Vanguard and Blackrock now have more than $10 trillion in assets under management.
Worst though, are when the fund managers try to get smart and in addition to picking (bad) stocks, they also use financial derivatives to enhance their appeal. They do so, by selling call options on their holdings of equities to receive a small premium. Yes genius, you collect some money, but you also make less if the market goes up. There is no free lunch, and all this does is add fees, transaction costs and of course it takes away from the returns, however advertised as part of the “income” one is to receive. And there you have it, if you want income, buy some credit instruments like bonds or loans. If you want growth from holding equities, then buy some passive index ETFs. Combining the two is a bit like being half pregnant, and we all know how that works out.