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Three fund ideas harnessing the power of dividends

Investors may find that they don’t have much exposure to the ‘equity income’ style of investing, but in the interests of maintaining a well-balanced portfolio, it could be worth considering.

| 9 min read

Dividends are the distribution of profits a company makes to its shareholders. If you own shares in a company that declares a dividend, you receive a slice of that money. Often overlooked, dividends can form a substantial part of an investor’s return over the longer term.

Following a period where ‘growth’ investing harnessing technological change has been fashionable, dividends are coming back into focus. The latest edition of the Janus Henderson Global Dividend Index indicated record levels of dividends were paid in the first quarter of 2022. With growth sectors falling out of favour and investors more conscious of short-term cash generation, it seems more people are beginning to appreciate the power of dividends in a portfolio once more.

Confidence in the future

A steady return from dividends can help generate long-term returns and bolster portfolios in periods of market stress. Higher dividend shares often have the valuation ‘safety net’ of the income stream they provide, so they can be less volatile. Knowing that dividends are likely to continue rolling in is also reassuring, and their regular payment can reward those that keep invested for the longer term.

What’s more, dividends can make up a large proportion of returns. For instance, the US S&P 500 index has risen 221% in capital growth terms over the past ten years, but with income reinvested that rises to 268%. For the higher-yielding FTSE 100 in the UK, dividends have been even more vital. The ten-year capital return is 43% and with reinvested dividends, it is 110%. Source: FE Analytics, data to 01/06/2022; past performance is not a reliable guide to future returns.

Some of the best returns this year to date have come from high dividend-paying sectors such as energy and commodities. These previously neglected areas have become more attractive in the face of inflationary pressures – indeed they make up a large part of the basket of goods that is used to measure inflation, both directly in the form of energy bills and indirectly in their impacts on the prices of other goods and services. This is one reason why the UK stock market, with its exposure to these sectors, has been an outperformer this year.

More broadly, dividend payers have been resilient during the recent market volatility as the steady accrual of income has bolstered returns and more stable, cash-producing sectors have been prized. ‘Equity income’ funds and strategies harnessing dividends can therefore provide a stable core to a portfolio. Investors still get ‘paid’ during more difficult market periods when capital gains are harder to achieve.

The value of investments, and the income derived from them, can fall as well as rise. Investors may get back less than invested.

What are the risks?

When targeting dividend-paying shares, investors need to be aware of ‘value traps’. Sometimes the dividend yield on offer looks high but it isn’t always sustainable, in fact, it could be a sign of distress. In these cases, if the dividend is cut or cancelled then the shares could fall in value, possibly substantially. This is why investors should not solely focus on the highest dividend-paying stocks or funds. Securing a lower, growing income tends to be more important in the long run than achieving the highest starting yield.

At present, dividends in certain sectors could come under pressure from higher interest on debt, rising costs and a weaker consumer. Every company and sector has its vulnerabilities, so it’s a good idea to have a broad range in your portfolio. Company earnings, and therefore dividends, fall as well as rise, but over time as economies and industries expand there should be an upward trend in dividends, providing a reasonable hedge against inflation.

Turn income into growth using funds

If income isn’t required, an investor can elect to buy accumulation units in a fund, rather than income units which pay the income out. Accumulation units reinvest dividends for you to turn income into growth and allow you to automatically ‘compound’ your dividend returns.

In falling markets, this can be beneficial because the cash dividends are used to buy shares at lower prices. With equity income funds offering yields in the region of 3-5% currently, and with the potential for the income to grow over time, that’s appealing, though remember all yields are variable and not guaranteed.

Investors may find that they don’t have much exposure to the equity income style of investing given the lacklustre performance in recent years and the dominance of technology and other growth-orientated investments. In the interests of maintaining a well-balanced portfolio, it could be worth considering whether a greater allocation to the area is worthwhile.

Dividend-producing funds tend to be found in either the ‘Global Equity Income’ sector or the ‘UK Equity Income’ sectors. Other, more geographically specialist, dividend-based funds can be found in their respective broad geographic sectors such as Europe ex-UK and Asia ex-Japan.

Fund ideas

Investors can build their own portfolios of dividend-paying stocks, but funds offer a convenient means to achieve diversification across dozens of companies’ shares.

Here are some fund ideas our Collectives Research Team believe offer good quality options for new investment in their respective areas. They should all be considered long-term investments meaning five years plus and are provided for your information but are not a guide to how you should invest. Before investing in any fund please read the relevant Key Investor Information Document or Key Information Document, and Prospectus to ensure they meet with your objectives and risk appetite. The very broad risk category is indicated.

Trojan Global Income

Manager James Harries is attracted to more defensive, predictable companies that are capable of gradually growing their dividends despite what the wider economy throws at them. It can mean investing in somewhat dull businesses, but over the long term, it has been a fruitful strategy. Solid, reliable businesses capable of gradually compounding returns for investors and having a low degree of economic sensitivity can provide a powerful and reliable engine of return in a portfolio.

The approach tends to lead to a portfolio concentrated in the consumer staples, healthcare and software sectors and the avoidance of areas such as mining, autos, airlines and house builders. A typical holding has ‘quality’ characteristics that the manager tries to capture without paying too much of a premium above the valuation of the market as a whole. Given the approach, we would expect the fund to underperform in a strong economic environment when more economically sensitive businesses fare best but offer more resilience in a difficult or sluggish scenario.

M&G Global Dividend

Manager Stuart Rhodes aims to buy tomorrow’s rather than today’s high yielders. He is a strong believer that dividend growth drives share price growth, and that better overall returns are available from modest yielders growing their dividends quickly. At times, therefore, it may yield less than more mainstream equity income funds. However, the lack of a dividend target, plus the fact this is a global fund, affords Mr Rhodes a great deal of flexibility in terms of choosing companies for the portfolio.

It contains a core of dividend ‘bankers’, which are stable, multinational businesses in strong industry positions, but there is also exposure to disciplined companies in more economically sensitive industries to produce a well-rounded portfolio that can better keep up in rising markets compared to a more defensive equity income fund.

JOHCM UK Equity Income

The level of yield provided by the UK stock market is a major redeeming feature. This fund aims to generate a dividend yield that is above the FTSE All-Share Index through a strict yield ‘discipline’. Clive Beagles has co-managed the fund alongside James Lowen since inception in 2004, longevity rarely seen in modern-day fund management.

The managers seek to invest in fundamentally strong companies at an attractive price and relatively high starting yields. This promotes a naturally ‘contrarian’ style of backing out-of-favour, less expensive stocks.

The fund will typically have significant exposure to small and medium-sized companies, often giving it a different holdings profile from many other income funds and the broader index. With a decent exposure to energy and commodities, it could also harness increasing prices in these areas that are a particular cause of inflation at present.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

Three fund ideas harnessing the power of dividends

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Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplementary Information Document and Prospectus.