Equity income funds have traditionally backed quality, defensive large caps with predictable earnings and strong balance sheets, but the hunt for yield has pushed these companies on to high multiples. To counteract this, a number of funds – including the likes of Adrian Frost’s Artemis Income fund – have upped their exposure to cyclical names with less established dividend records, such as Lloyds and Rio Tinto.
While some investors may be wary of these kinds of companies appearing in their core UK Equity Income holdings, Younes (pictured) says that managers have no choice but to look further afield for their stock-picks.
"The valuation differential between quality large caps and more cyclical areas is just too high now," he explained.
"This is why you’re seeing managers like [Adrian] Frost and [Adrian] Gosden going into the banks and commodities, even though something like Rio Tinto has had some pretty irregular dividend payments in recent years."
"The problem these managers have is that on one hand you have market risk, and on the other you have company risk. This rally has been liquidity-fuelled, rather than one led by earnings, which have been pretty poor."
"When quantitative easing is eventually tapered next year, it’s going to be the bond proxy-stocks that get worst-hit. This will include some of the large cap telcoms and healthcare stocks that have had a good run."
"If you want to avoid these, you’re going to have to take on greater company-specific risk, which puts managers in a very difficult situation. Essentially it’s lose-lose – you either have to take on market risk or company risk."
With a yield of 4 per cent and a forward price/earnings (P/E) ratio of 10 times, Rio Tinto is one of the cheaper income options in the FTSE 100.
FE data shows that 23 UK Equity Income funds currently hold the miner in their top-10, including Artemis Income, Cazenove UK Equity Income and Lazard UK Income.
UK retail banks are a particularly unconventional choice, given that they currently don’t pay a dividend. However, thanks to their historically cheap valuations, and the fact that most commentators predict that they’ll be paying a dividend by this time next year, the likes of Lloyds and Barclays are popular choices in the sector.
Schroder Income and Jupiter Responsible Income are two of five funds in the sector that hold Lloyds in their top-10. Barclays is even more popular, appearing in the top-10 of 13 UK Equity Income funds overall, including Cazenove UK Equity Income and Schroder Income Maximiser.
Although both Barclays and Lloyds have had a strong run of late, all three stocks have significantly underperformed the FTSE 100 over a three-year period.
Performance of stocks and index over 3yrs
Source: FE Analytics
JP Morgan’s Ben Stapley identified some other off-piste UK equity income stockpicks in a recent FE Trustnet article.
A similar trend is also occurring in the European equity income market, as explained by Cazenove’s James Sym. He argues that it is actually riskier to be in supposedly defensive quality stocks at the moment, as their valuations are so high.
"Of course, a company of a high quality should be on a higher premium, but the premium has got egregious and the valuation gap is now too wide. I don’t think you’ll lose a lot of money from Nestle from this point, but I think it will be difficult to make money over the next 10 years."
Sym likens the situation to the "nifty-fifty" in the US in the 1960s and 1970s, when previously top-performing secure-growth companies suffered a sustained period of underperformance versus the wider market.
The upping of risk exposure is not exclusive to the equity income market. Younes points out that many mixed asset and bond managers have also looked to more volatile areas of the market in order to find better valuations and yield.
FE Alpha Manager Ariel Bezalel (pictured), for example, who runs the Jupiter Strategic Bond fund, has a hefty weighting to Greek and Cypriot government debt, in an attempt to maintain his healthy 5.2 per cent yield.
"In fixed income it all depends on when you think yields are going to rise," Younes said. "The managers who think they’re going to rise very shortly are defensive right now, but if you think yields will stay lower for longer – as Bezalel does – then it’s possible to add value with some riskier special situations." "Greek and Cypriot government debt is yielding around 9 per cent. There is some asymmetric risk there, but given he’s only in short-term paper, he thinks they’re worth the risk."
Similarly, FE Alpha Manager Robin Hepworth, who runs the Ecclesiastical Higher Income fund, has the highest weighting to equities he has ever had, at 75 per cent.
Click here to learn more about bonds, with the FE Trustnet guide to fixed interest.
However, Younes says he can understand why a mixed asset investor would have the bulk of their assets in equities, even though they tend to be more volatile than bonds.
"If you’re invested in bonds at these levels, it’s very difficult to make a capital gain," he explained.
"In equities there is perhaps more market risk, but you need to go where the best value is."
"I think managers are making these calls for the right reasons – you just have to understand why they are doing it," he added.