With a growth fund, most investors will start by looking at past performance and how it measures up against its peers; this gives you an idea of how successful the manager’s past stock-picks have been.
However, as many experts point out, past performance is not necessarily an indication of future returns, although it does demonstrate a manager’s ability to pick stocks throughout varying market conditions.
Similarly, you may want to start your search for an income fund by comparing yields – but picking the highest-yielding fund is rarely a good strategy.
FE Trustnet research has previously shown that the highest-yielding UK equity income funds tend to underperform their peers.
One of the main reasons for this is that the companies that pay the highest dividends are often those that are in some financial trouble, meaning that the share price eventually suffers.
This means that investors need to do their research before making a choice, and the starting point is taking a good hard look at what you aim to achieve with an equity income fund.
Income or growth
Equity income has been extremely popular in the years following the financial crisis and it is not only investors who need to draw an income who have been buying the funds.
Typically companies that are better-defended against problems in the economy pay out higher and more consistent dividends.
This is because they have less motivation to re-invest their money in their business or battle with competitors – such as utility companies.
Many investors have been keen to hold such companies to protect themselves against the market volatility of recent years.
Investors of this type can also choose to reinvest any income they earn from these portfolios. The process is called compounding and it can massively increase the growth of your portfolio.
A recent FE Trustnet article showed investors could get similar capital returns from both equity income funds and growth-focused ones.
Jason Hollands, managing director of Bestinvest (pictured), said: "What fund you look for depends on whether you need to draw the income.""Lots of people like the type of cash-generative businesses that the funds hold. Those that actually do want the yield might want a more aggressive yield target."
"However, clearly you should not be choosing simply on the basis of headline yield, because one of the reasons why the yield may be high is because the market believes it’s not stable."
However, many managers aim to increase their dividend every year and this objective is something investors can look for when selecting a fund, although this style does have its own drawbacks.
Chris Spear, managing director of Spear Financial, said: "Yield is a factor, but not the only one, as some fund managers have realised."
"They have changed the fund's mandate to stop slavishly looking to grow yield each year at the expense of capital preservation and growth."
One complication is that it is hard to find data on what the yield has been in the past, and figures usually quoted on marketing material are for the past 12 months only.
Style and process
Whether your goal is income or growth, to pick the right fund you need to look at the fund manager’s style.
Hollands said: "When we are looking at a fund’s track record, total return [the combination of capital performance and income] is a starting point, and it is important, but then you need to understand the style and the process the manager puts in place."
"There are funds out there like Unicorn Income, for example, which has a stellar track record but is investing in smaller companies. This means you are taking on substantially more risk with that fund than with those that invest in larger firms."
Performance of fund vs sector over 5yrs
Source: FE Analytics
Data from FE Analytics shows that Unicorn UK Income has made almost four times as much as the average fund in the IMA UK Equity Income sector over the past five years.
Smaller companies have greater growth potential, but FE Alpha Manager John McClure has undoubtedly shown great skill to make 112.53 per cent for investors in this time, while the sector is up just 30.04 per cent.
The fund is slightly more volatile than the average fund in the sector and this is another feature common to smaller companies funds.
It may appeal to those who want to reinvest dividends, but only if they are prepared to take on the extra risk.
The majority of income funds concentrate on larger companies because it is more difficult for them to continue growing and therefore they pay out a proportion of their profits to shareholders.
With this type of fund it is vital to look at sector exposure and, depending on your attitude to risk, avoid funds that are tilted towards more volatile areas of the market, such as financials or mining.
"Sector exposure has been simple. You are either in financials or you are not," Spear (pictured) said. "The non-financials managers offered the smoother ride through the credit crunch, but the tables have been turned as markets have realised that banks and countries will not be allowed to fail."
"Neil Woodford has traditionally been anti-banks, while Anthony Nutt at Jupiter tended to include financials."
"But it is worth remembering that Bill Mott paid the price for his holdings in banks."
According to Hollands, a wider variety of companies now pay out dividends, meaning that investors need not be trapped in the traditional "defensive" sectors such as utilities, tobacco and pharmaceuticals.
"In the past, income funds tended to have a high concentration to certain sectors such as tobacco, but one strong theme in the market last year has been more companies starting to pay dividends in record numbers," Hollands said.
This means that it is possible to diversify your sources of equity income, either by choosing a fund that has spread its sector exposure or by choosing a number of funds with different sector biases.
Juliet Schooling-Latter (pictured), head of research at Chelsea Financial Services, said: "If you are going to have more than one equity income fund it is important to have a bit of diversification."
"You could have an equity income fund that goes into smaller and mid caps as well to avoid doubling your exposure."
Manager record
The way a strategy is implemented depends on the style of the manager and there are some managers with very long track records of good performance in the sector.
Schooling-Latter said: "You need to look at the track record of the fund manager – not necessarily the fund, because the manager could have changed recently." However, Spear points out that picking a manager based on their track record is not a foolproof technique.
"I have just had a client in my office who invested in the original Credit Suisse Income fund that Bill Mott managed. He had a great track record, which sadly did not continue into Psigma."
"But look at his former colleague, Leigh Harrison of Threadneedle. I think he does not get the attention that I think he should. He's been consistent and has had a very strong team behind him."
Data from FE Analytics shows that the Threadneedle UK Equity Income fund has returned 41.63 per cent over the past five years, compared with 23.23 per cent from Psigma Income fund.
The yield on the funds is currently almost identical, however, with the Psigma fund’s 4.05 per cent narrowly ahead of the Threadneedle fund’s 4 per cent.
Spear thinks investors should consider managers with a shorter track record of performance if they are exceptional.
"We have seen a lot of interest in Standard Life's UK Equity Income Unconstrained fund, managed by Thomas Moore," he said.
"Frankly, he is young, not having the experience of a Leigh Harrison, but yet again he has a strong team behind him. I would say that there is a fund which performs well in a rising market, but underperforms in a bear market."
Passives
Investors who don’t want to, or don’t have the time to, research the manager of their funds may like to consider passive options in the area, which FE Trustnet recently looked at in some detail.
Spear adds that passives are a good option for those who want to cut the cost of investing.
"I like active management, but not at any price," he said. "I think credit needs to be given to Vanguard for their FTSE UK Equity Income Index fund. It has very low charges (0.25 per cent TER), but with a yield of 4.7 per cent."
"It's not easy to invest directly into it because of Vanguard's high minimum investment, but it deserves to be included. If you use a SIPP or a wrap, those minimums are usually waived."
Overseas
There are a number of equity income funds available that operate globally, in the US or in emerging market regions such as Asia.
Schooling-Latter says they can be used to diversify portfolios rather than replace UK equity income funds.
Spear added: "When thinking about asset allocation, I am happy to consider both, particularly as the Far East and emerging markets are all beginning to see that using dividends is a way for company bosses to keep shareholders happy and hence keep their jobs."
Spear tips M&G, Newton and Threadneedle for generalist global equity income funds.
"You can't beat experience," he said.
"It may also be a good time to look at Europe – try Standard Life European Equity Income or BlackRock Continental European Income."