Equity income is traditionally seen as a defensive asset class, but data from FE Analytics shows that if investors reinvest their income they can make large capital gains.
Assuming dividends are reinvested, the average UK Equity Income fund has made almost identical returns to that of the average IMA UK All Companies fund over the past decade, according to our data.
Performance of sectors over 10-yrs
Source: FE Analytics
Gee says this shows that investors do not need to switch out of their income funds to take advantage of this year’s market rally.
"You do not need to be an income investor to be investing in equity income," she explained. "We use the funds as part of all our investors’ portfolios." "It’s the dividend play as an asset class rather than an investment requirement that you are looking for."
Equity income funds tend to invest in more defensive companies, as these pay out a greater proportion of their profits to shareholders rather than reinvest in the business.
They are typically mature companies in mature markets with limited prospects to grow at a fast pace, which is why there is the expectation that income funds should perform weakly on a capital return basis.
However, our figures show that if someone had reinvested the dividends paid by these companies back into their portfolio, the total return would match that available from the IMA UK All Companies sector, in which the funds explicitly target capital growth.
Given that equity income funds do invest in more defensive areas, they often offer superior downside protection than pure growth plays.
Our figures show that the UK Equity Income sector has a volatility score of 13.31 per cent over 10 years, compared with 14.73 per cent from the UK All Companies.
However, although the sector averages perform roughly in line over three, five and 10 years, there are some funds in IMA UK All Companies that consistently beat both sectors.
These are almost exclusively funds that invest in mid-sized business down the market cap scale.
Mid caps have more potential to grow their earnings and this means they have greater potential for share price increases.
Smaller companies get less attention from analysts and market participants, meaning there is greater scope for managers to discover information or develop insights that others do not have.
A list of top-quartile funds over the past decade in the IMA UK All Companies sector is dominated by mid cap focused funds, and that quartile has significantly outperformed its equivalent area of the IMA UK Equity Income sector over this time.
Performance of top-quartile funds over 10yrs
Source: FE Analytics
The 15 best-performing retail funds in the IMA UK All Companies sector over three years all have a mid or small cap bias.
The fund with the best returns in the sector is Neptune UK Mid Cap, managed by FE Alpha Manager Mark Martin.
It has made 85.13 per cent in this time, after the effects of a 2 per cent total expense ratio (TER).
Performance of fund vs sectors and benchmark over 3-yrs
Source: FE Analytics
This compares with 32.87 per cent for the average All Companies fund and 33.1 per cent for the average UK Equity Income fund.
Gee says that if investors want to take maximum advantage of a bull market, they should look to mid and small cap funds.
"If you were very growth-focused and risk-savvy you would switch to smaller companies funds," she said. "That would be the move, but it would take tolerance to risk to cope with that change."
"If you now think that markets are in positive territory, there’s a stronger case for holding small cap funds."
FE Trustnet research has previously shown the huge potential of outperformance in the UK Smaller Companies sector.
However, it comes at the cost of significantly higher volatility and a higher risk of losing money, making mid caps an interesting compromise.
Gee is not taking the current rally at face value and prefers to keep her clients in equity income funds – even those who are not drawing the income.
"Personally I am neutral on the current rally. I think there are some positive signs but the problems of last year haven’t gone away," she said.
"Plus, for those of our clients who are retired, they can’t go out and make their money again, so that limits their ability to take on more risk."