An income fund is tailored to pay out a dividend yield on top of any capital gains.
Investors have the choice of taking the money and using it as a source of income, or re-investing it in the fund.
If they choose the latter, the principles of compounding interest come into play and the returns on a portfolio can escalate rapidly, as shown by FE Trustnet research.
Neil Woodford's Invesco Perpetual High Income fund is a good example of the impact re-investing dividends can have on total returns.
The five crown-rated portfolio is currently yielding 3.58 per cent. A £10,000 investment in the fund 20 years ago would have resulted in an income payout of £21,928.49 – after the basic UK tax rate.
The capital appreciation of the fund alone would have turned the original £10,000 investment into £48,153.26. Adding the additional income over the years, investors would have seen a total return of £70,081.75 from the fund.
However if investors had kept that money in Woodford’s hands, they would have made £96,558.06 on that initial investment – more than £26,000 more than if they had chosen not to re-invest dividends.
Performance of fund with and without dividends re-invested
Source: FE Analytics
Even over an investment period of as little as three years, the effects are noticeable.
For example, Fidelity Enhanced Income was recently chosen by Rob Gleeson, head of FE Research, as his income fund pick.
An investor who had bought the five crown-rated portfolio at launch in 2009 and decided to keep their income would have missed out on nearly 40 percentage points on the upside, without taking the income over the investment term into account.
Performance of fund with and without dividends re-invested
Source: FE Analytics
In nominal terms, this means if they had invested £10,000 initially, this would have risen to £12,000, while the income paid would have amounted to £3,422.64.
In total this is £500 less than the £15,864.49 figure that would have been accrued had dividends been re-invested.
The yield on the Fidelity fund, at 7.11 per cent, is relatively high for the sector.
The benefits of re-investing dividends are more pronounced the more money that is put in and the longer it is invested for.
Looking at the popular four crown-rated Artemis High Income fund, which is yielding 5.92 per cent, a £10,000 initial investment over a 10-year period would have brought in £21,874.91, with dividends re-invested.
Spending this income would have meant the total investment was worth £1,595.32 less over the period - the initial investment would have grown to £12,093.36, while payouts would have totalled £8,186.23.
Performance of fund with and without dividends re-invested
Source: FE Analytics
For the purpose of clarity, monthly savings plans have not been included in these figures; however the difference in total returns is even more pronounced when a drip-feeding technique is used.
Gleeson points out that the point of investing in income funds is to receive a regular payout – whether that is monthly, quarterly or yearly – and for investors who do not need to keep their income, he says there are better options available in more growth-oriented areas.
"For investors who don’t need an income, they’d be better off in growth portfolios such as pure equities or emerging markets," he said.
However, Gleeson adds it all depends on what people want from their fund.
In a previous article, FE Trustnet research found that when dividends were re-invested, the IMA UK Equity Income sector made almost identical returns to that of the average IMA UK All Companies fund over the past 10 years, and often with less volatility.
However, investors do need to keep sight of their objectives and note that if they need money for a short-term goal, such as a house payment, school fees or family holiday, a steady and reliable stream of income could be the best bet.