Hudson (pictured), who heads the five crown-rated Cazenove UK Equity Income fund, says that protecting capital does not just mean holding defensive positions when markets drop, but also requires managers to move into higher-risk assets in order to participate in rallies. "On a general basis, other equity income funds look at capital protection as performing well when markets are in a downturn," he explained. "Yes, we need to be protecting capital on the way down, but another part of capital preservation is making high returns when markets rally – it’s all relative in that respect."
"We are top-down, business-cycle investors who are fundamentally thinking about stocks and where they are in these cycles. This is key when looking at markets where everyone is either overly jubilant or über depressed – it is all based on a stock's relative valuation."
The manager says investors need to take a top-down view in order to maintain consistent returns, as he believes a bottom-up approach could limit opportunities.
He highlights the multi-national consumer goods company Unilever – a popular holding with equity income funds and stockpickers – as an example of a solid income-generative stock that will not keep up with a market rally.
"I think a top-down view is a more flexible way of going about it," he said.
"A lot of people bought into Unilever – it had a strong balance sheet and was distributing a good dividend. However, it is constantly re-rated and is a low-growth prospect. Investors were saying ‘give me something that can deliver income’, but you have to be buying it at the right multiple."
"If you expect the last five-year period to repeat itself then it is fair value, but if anything else happens then a lot of investors who have bought it will be missing out."
Twenty-three of the 99 funds in IMA UK Equity Income currently hold Unilever in their top-10, including Francis Brooke’s Trojan Income and Michael Clark’s Fidelity Enhanced Income.
Hudson’s approach has so far worked well; according to FE Analytics, his Cazenove UK Equity Income portfolio has registered top-quartile performance over one, three and five years.
Performance of fund vs sector and index since May 2005
Source: FE Analytics
Hudson has managed the £157m fund since its launch in May 2005 and over that time it has returned 84.50 per cent. This is more than its benchmark – the FTSE All Share – and the IMA UK Equity Income sector, which have made 70.91 per cent and 57.86 per cent respectively.
It is the only fund in the sector that can boast top-quartile performance over the last three discrete calendar years.
Cazenove UK Equity Income – which is currently yielding 3.8 per cent – has tended to be more volatile than the sector average; however, crucially it has a lower max drawdown and max loss than both its peer group and the All Share.
The manager says that in order to deliver consistently high capital returns from an income-generative portfolio, he employs a "three cogs" asset-allocation strategy.
"Our allocation to the three cogs – premium high yields, capital returns and superior dividend growth – changes through the cycle, so that we can deliver the best income and capital returns," he explained.
"Premium real yields are the type of companies that I need to achieve my premium yield."
"These are pharmaceuticals, food retailers and also companies like HSBC. Though it has a higher Beta than most, HSBC is a safe banking stock that has a very well covered dividend."
"We usually have a high weighting to these stocks when the market is slowing, so for instance in December 2008, 86 per cent of the fund was in premium real-yield positions."
"Capital returns are usually cyclicals – I buy them when the market is entering its recovery phase. For example in 2009 we bought a lot in banks and miners such as Rio Tinto, which wasn’t really yielding anything at the time. However, these stocks meant we could outperform as they gave you real bang for your buck."
"After the recovery phase we look to superior dividend growth; basically companies that focus on increasing their yield. These are companies like Babcock and the food retailer Compass, which on average are seeing nominal dividend growth of about 4 to 5 per cent."
Hudson says he is currently bullish on the UK markets and has his fund more tilted towards capital returns and "superior dividend growth".
He currently has 25.57 per cent of the portfolio in financials, and counts HSBC and Barclays in the fund's top-10 holdings.
Cazenove UK Equity Income has a total expense ratio (TER) of 1.58 per cent and requires a minimum investment of £1,000.