Just two of funds in the IA UK Equity Income sector have an information ratio that suggests their returns over the long run have been down to consistent skill at active management, FE data suggests.
In this ongoing series, FE Trustnet is assessing funds’ long-term results using the information ratio – which is as an expression of the success of a manager’s active decisions away from the benchmark for each unit of extra active risk taken on.
Having looked at funds in the IA UK All Companies sector and global equity strategies, this study looks at the five-year information ratio of all IA UK Equity Income funds with a track record going back to at least the start of 2007 and an r-squared ratio to the FE All Share index of at least 0.6 (to make sure the results are statistically significant).
We’re using rolling five-year periods going back to the start of 2000 (or the funds’ full history, if shorter) to find the average information ratio for the total period, thereby ensuring that any strong performance has persisted over the long term. This is a very tough test for funds, so it’s not surprising that relatively few have gotten through.
Rolling five-year information ratios of JOHCM UK Equity Income and IA UK Equity Income sector
Source: FE Analytics
With the information ratio, the higher the result the better as it suggests that a manager’s active decisions have led to superior risk-adjusted returns. A figure of 0.5 is considered to reflect good performance, 0.75 very good and 1 outstanding.
When applied to the IA UK Equity Income sector, none of the funds eligible for inclusion in this research achieved a ‘very good’ or ‘outstanding’ results according to our long-term rolling criteria.
The fund with the highest rolling five-year information ratio features in the chart above: JOHCM UK Equity Income. It scored 0.56 in this research, compared with an average from the IA UK Equity Income sector of just 0.09.
JOHCM UK Equity Income is headed up by James Lowen and Clive Beagles. The £3.5bn fund was top quartile in its peer group over 10 years to the end of May 2019 with a 200.29 per cent total return, while being first-quartile over three years and second-quartile over five; however, it falls into the bottom quartile over shorter time frames.
Lowen and Beagles place yield discipline at the heart of their investment approach. In order for a stock to be included in JOHCM UK Equity Income’s portfolio, it has to yield more than the FTSE All Share index on a prospective basis.
There is also a strong sell discipline, with stocks being sold if they rise in value to the point where they are yielding the same as the market. This approach tends to lead to the portfolio having a contrarian tilt.
In a recent outlook, the managers noted that the valuation gap between quality-growth and value stocks is currently at “more extreme” levels than were seen during the tech bubble of the late 1990s.
They argued that this has created “significant valuation risk” around large parts of the market, such as growth stocks, defensives, bond proxies, consumer staples and healthcare – which JOHCM UK Equity Income is relatively unexposed to.
This bias towards value explains some of the fund’s underperformance over more recent time frames, but Lowen and Beagles believe this positioning will pay off in time.
“As ever, we remain focused upon valuations. In this regard, we remain very optimistic about our portfolio. There are a few examples where valuations are getting fuller and where we are reducing exposure e.g. HSBC, National Express, etc. However, these examples are limited to much less than 10 per cent of the fund,” they said.
“The vast majority of the fund therefore remains very cheap, in our opinion. This value trajectory and continuing fund dividend growth should underpin good relative performance over time.”
Rolling five-year information ratios of Schroder UK Alpha Income and IA UK Equity Income sector
Source: FE Analytics
The only other member of the IA UK Equity Income sector to have a rolling five-year information ratio in ‘good’ territory is Schroder UK Alpha Income. It has an average information ratio of 0.5.
The £189m fund has been managed by Matt Hudson since May 2005 and, like JOHCM UK Equity Income, is in the top quartile of the peer group over 10 years to the end of May 2019 but slips further down over shorter time frames. Over the past decade, it has made 174.13 per cent against 145.48 per cent from its average peer and 149.39 per cent from the FTSE All Share.
Hudson manages Schroder UK Alpha Income using the firm’s business cycle approach, which assesses stocks on whether the wider economy is in the expansion, slowdown, recession or recovery phase of the cycle. For example, the portfolio might be overweight cyclicals in the early recovery part of the cycle before moving more towards defensives as the economy starts to slow down.
In the context of this equity income portfolio, it tilts towards dividend growth opportunities in the expansion phase, towards market yield and dividend growth in slowdown, towards high secure yield in recession and towards low/no yield but high capital growth stocks in recovery.
In a recent update, the manager explained how the current positioning of the portfolio fits into this framework: “I believe that this will become the longest business cycle on record, but we are late in the cycle and a more defensive skew is appropriate, especially after the rally year to date.”
While the two above funds are the only members of the IA UK Equity Income sector to score a ‘good’ result in this research, three more had rolling five-year information ratios of between 0.4 and 0.5: Royal London UK Equity Income, Aviva Investors UK Equity Income and Threadneedle UK Equity Alpha Income.