With interest rates at historic lows and predictions of a year of severe dividend cuts as hardpressed companies seek to survive the recession, investors whose priority is generating income, without running down their capital, are also feeling the pressure.

Undoubtedly, there are some funds with very attractive yields out there, but investors will be rightly cautious about headline yields that seem too far out of line with the market norm.

Traditional investment wisdom states that an exceptionally high yield on a share is usually a sign of long-term weakness, and although the dramatic fall in share prices means that sustainable yields are currently higher than should be possible with the base rate below two per cent, income investors will still need to tread carefully.

In white and black
So where should investors be looking for income? And which funds should be avoided?
Principal Investment Management has recently published the latest issue of its Income Study, which focuses on the UK Equity Income sector. For over 30 years, this research has focused on identifying those funds that met the twin goals of delivering an attractive level of income and long-term capital appreciation.

At the same time, it highlights those UK equity income funds that consistently fail to meet these objectives. As Charles Brand, director for managed funds at Principal, points out, ‘While dividends across the market are likely to be lower in 2009, the best equity income managers will be focused on selecting companies with resilient earnings, strong balance sheets and robust cash flows. These companies will be well placed to deliver attractive dividend payments in what will be a low-income environment. As a result, high-quality UK equity income funds should find favour.’

The study separates UK equity income funds into three groups: the White List (funds that have delivered both capital outperformance and a high level of income over the past five years); the Grey List (an early warning sign of a struggling fund manager, or simply a signal that an investment process is currently out of favour); and the Black List (funds that have regularly disappointed).

Brand acknowledges that ‘2008 was a terrible year for equity investors, and the equity income sector was no exception.The financial crisis and subsequent economic slowdown led to sharp falls across all markets. However, drastic action from global central banks has seen interest rates fall dramatically.The UK base rate now stands at 1.5 per cent, and may fall further, leading to income becoming a scarce resource.’

He adds, ‘In this environment, capital is likely to be driven towards asset classes with a track record of generating an attractive level of income, and the UK Equity Income sector
fits the bill.

The good, the bad, the maybe
Brand highlights three groups whose equity income funds are firmly at the top of the White List: ‘The unwavering outperformance of Neil Woodford cannot fail to impress, and Invesco Perpetual Income and High Income remain essential holdings. Artemis Income is another of the sector’s outstanding funds.Adrian Frost and Adrian Gosden have an investment process focused on company cash flows, which should serve them well in the coming year.’

He adds,‘It is also significant that Newton Higher Income makes a return to the White
List. Its resolute focus on yield has seen it lag the sector at times. However, its recent
avoidance of banks and miners has led to improved performance.’

With regard to the ‘watching brief ’ of the Grey List, Brand notes that ‘While established equity income managers Nick Purves [Schroder Income] and Anthony Nutt [Jupiter Income] reside in the Grey List, they have proven track records and deserve the continued faith of their investors.’

Turning to the underperformers of the Black List, he notes that ‘Scott McKenzie enjoyed
some strong spells of performance while heading Norwich UK Equity Income. However, he has so far been unable to turn around the flagging fortunes of Martin Currie UK Equity Income.’

Ceasing to roar
Another addition is Liontrust First Income. ‘The resignation of Jeremy Lang was a big shock to the industry and investors in Liontrust First Income.While recent performance had been disappointing, his distinctive investment approach had generated strong absolute returns and a rising level of income since the fund’s launch in 1996.Without Lang, there is little reason to own this fund.’

This refers to the news that broke in mid December that Jeremy Lang and William Pattisson, two of Liontrust’s key fund managers, had announced their intention to leave the group. Although they are not actually going until January 2010, the assumption is that the impact on the funds they manage will be more immediate.

Darius McDermott of Chelsea Financial Services opines that ‘Lang and Pattisson are
part of Liontrust’s DNA.Their signature investment process has not only become the sacred writ of the company’s approach to asset management, but commanded the faith of a wide range of investors.’

He adds,‘The news will be particularly perplexing for retail investors. Lang runs
approximately 80 per cent of Liontrust’s retail money. One might argue that he has been under pressure to improve the performance of his Liontrust First Income fund – a high-profile laggard in the Income sector for the fourth year running in 2008. However, I do not see this as a performance-related decision, given how highly regarded these managers are, and I have doubts about whether new managers can step in and carry on the various funds’distinctive processes.’

And now the cutting begins
And the changes at Liontrust are not the only things to worry equity investors at the moment. Brian Dennehy, managing director of adviser Dennehy Weller, feels that ‘As interest rates continue to plummet towards zero per cent in 2009, the attractions of dividend income are, on the face of it, startling. Investors are being hit by a double-whammy: falling interest rates plus rising utility costs and food prices.Therefore, it is important to seek out new income generators, either by buying the income-generating equity shares or by purchasing equity income funds.’

He warns that ‘While buying at current levels could be a rare opportunity, caution is needed as, in November, we saw 27 per cent of all income funds announcing their dividends reduce their payouts.This is a very clear early indicator of the risks in 2009, as profits, and therefore dividends, at individual companies come under severe pressure.

Equity income funds are very attractive as dividends are much less volatile, and more reliable, than both the stock market and interest rates, but some funds will be forced to reduce dividends.’

However, Dennehy adds that ‘The December results were more encouraging. Of 12 funds, there was only one cut compared with the same period in the previous year, but this month could prove to be an exceptionally positive one, once individual quoted companies begin to announce dividends over the next two months. Although Neptune cut the payout compared with the same period last year, the income generated over the whole of 2008 is still higher than 2007. We need to ensure this is not the beginning of a trend so will keep a close eye on the mid-2009 payout’.

A scarcity of high income
To help investors keep up with changes in dividends, Dennehy’s firm has recently
introduced ‘Dividend Watch’, a free monthly email service that aims to track changes in funds’ dividend payments, highlighting changes in payouts and which funds to buy or avoid. Investors can register for the updates at DividendWatch@DWCifa.com.

Dennehy confirms,‘We certainly live in unprecedented times, and while lowering interest
rates is the government’s attempt at kick-starting the economy, it ignores those investors that rely on their savings to supplement their income.’

He points out that ‘High income, by which we mean six per cent plus, will have an increasing rarity value in 2009. The current yields on wellestablished equity income funds, for example from Newton and M&G, exceed six per cent, which is very attractive for those seeking income, if such payouts are maintained.’

However, Dennehy also acknowledges that the pressure on dividends will make life more testing for income fund managers in 2009.

On the defensive
Looking more generally,Tom White a data analyst at Bestinvest, highlights those fund
managers who were able to provide their investors with strong returns during the turmoil
of 2008.White says,‘2008 has shown the benefits of a macro view but also the dangers. Managers who bet on the longterm prospects for emerging markets and commodities may ultimately be correct, but they came unstuck last year. It was a year when many
stockpicking managers also suffered. It was no use being in the right stocks when you were in the wrong sector, or country, or currency. In the long run, we expect a return to a stockpicking environment as markets settle down, but for the moment we remain cautious.’

He points out that ‘A number of equity funds were able to achieve good relative returns during the year, principally by taking a defensive stance. Cazenove’s Chris Rice is a rare manager who combined astute macroeconomic calls with strong stockpicking.

During 2008 he took overweight positions in defensive sectors such as food, beverages and utilities and was underweight banks and commodities, enabling his Cazenove European fund to outperform the FTSE Europe ex UK benchmark by 15 per cent.’

He adds,‘The Asian and emerging market funds of First State and Aberdeen also
outperformed strongly, due to their focus on quality businesses at attractive valuations as market movements sorted the wheat from the chaff. Elsewhere in a tough year for global funds, Mellon’s James Harries was able to boost returns on Newton Global Higher Income by hedging out his sterling exposure as the currency plummeted.’

And no fund analysts can go for long without singing the praises of Invesco Perpetual’s income fund manager. White points out that ‘Neil Woodford made his name by eschewing technology stocks during the tech boom of the late 1990s, a position that was vindicated when they subsequently collapsed. Since then, he has made a habit of calling market movements correctly, and when we spoke to him in 2007 he was already predicting recession. He went into 2008 with a zero weighting to banks and, though his High Income fund dropped almost 20 per cent on the year, this was 15 per cent better than the FTSE All Share index.’

Absolute returns Even this level of performance will not be to some investors’ taste, however. For those looking to at least maintain the value of their capital in these troubled times,White suggests that some of the absolute return funds are meeting their objectives.

He says, ‘BlackRock UK Absolute Alpha hasn’t maintained the heights of recent years, but still rose by 1.53 per cent over the 12 months to the end of 2008, while Cazenove’s UK Absolute Target fund is already up 5.06 per cent since its launch in July, far in excess of traditional UK equity funds. However, overall the IMA Absolute Return sector fell by 0.56 per cent during the year, showing that investors still need to choose the right funds.’

He reports,‘Just three IMA sectors made money during 2008.The UK Index Linked Gilts sector, including the Bestinvest-rated Royal London Index Linked fund, was up 2.98 per cent and the UK Gilts sector was up 11.63 per cent, as investors took shelter in government-backed assets. However, the topperforming sector was Global Bonds, which rose 16.36 per cent in the year. Most funds in this sector invest primarily in overseas government bonds and so benefited not only from the flight to safe assets, but also from the appreciation of overseas currencies against sterling.’

White adds, ‘Some funds did better still. Among our recommendations, Baring Global Bond was up 31.13 per cent on the year, Invesco Perpetual Global Bond was up 22.67 per cent and Thames River Global Bond rose by 35.81 per cent. But, as always, investors should be wary of taking past performance at face value. Government bonds are now trading at historically high valuations, suggesting this performance is unlikely to
be repeated going forward.’

He also points out that ‘While the Global Bond fund managers were arguably just in the
right place at the right time, one manager was able to add value while investing in one of the worst-performing sectors. Philip Gibbs’s Jupiter Financial Opportunities fund rose 7.32 per cent, despite the disasters that befell the banks which make up much of its investment universe – the FTSE World Financials index by comparison dropped 35.32 per cent. When we saw Gibbs early last year he was already predicting hedge fund closures and banking collapses and positioned the fund accordingly, using cash, fixed-interest and index shorts to protect investors.’