Senior Investment Analyst Lin Ngin commented, “Products simply buying stocks expected to deliver higher dividends are being left behind in terms of innovation.”

“While it is still early days, the performance of many long-only products within the Equity Income sector is lagging their more innovative brethren.”

One particular element of this performance differential between long only funds and products able to implement derivative strategies is their ability to participate in corporate activities (such as share buy-backs) for lower yielding stock, which has resulted in a noticeable uplift in franking level for the more innovative strategies.

Historically equity markets have not provided consistent income via dividends along, therefore Lonsec believes funds that are able to diversify the composition of their distributions are generally better positioned to provide a stable income stream.

“Lonsec has a higher regard for funds able to provide consistent income without eroding the capital base,” said Ngin.

The review
Lonsec’s Equity Income Sector Review covered nine managed funds and four exchange traded funds. Across the active funds rated, only two were awarded Lonsec’s highest rating, ‘Highly Recommended’ – the Zurich Investments Equity Income Fund and the Colonial First State Wholesale Australian Equity Income Fund.

In addition, the review considered five prospect funds, one of which was added to Lonsec’s recommended list, the Legg Mason Australian Equity Income Trust. Lonsec considered some prospect funds that focused on investing globally.

“Currently there are no funds on Lonsec’s recommended list that invest predominantly in offshore assets,” said Ngin.

“However, we believe that products focused on income generation will continue to develop and are likely to broaden their investment horizons to include asset classes such as global equities, fixed income and other Australian equity strategies.”

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Standard & Poor’s Fund Services today assigned its four-star ‘NEW’ rating to the Russell Australian After Tax Fund and its three-star ‘NEW’ rating to the Russell Enhanced Income Shares Fund.
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The Russell Australian After Tax Fund is specifically targeted to superannuation investors. It has three layers, the foundation of which is the Russell Australian Shares Fund, which aims to deliver long-term returns by investing in a portfolio of Australian equities chosen by select investment managers and has been running since 1997. The After Tax Fund is managed according to a “tax-aware” strategy, rather than a “tax-driven” strategy. Russell has introduced tax considerations as an adjunct to its underlying investment method. Ultimately the criteria are intended to maximise after-tax alpha. We consider the tax-aware component of the fund to be comprehensive and effective.

“We also have a high regard for the manager’s multi-manager investment team and process. For this particular fund, portfolio manager Scott Bennett and tax consultant Raewyn Williams are experienced in their respective areas of responsibility. The fund does not have an adequate track record to provide a guide to its tax effectiveness as yet. However, the underlying Russell Australian Shares Fund has performed solidly, recording alpha consistently over a full market cycle and significantly outperforming in down markets,” said S&P Fund Services analyst Rodney Lay.

The Russell Enhanced Income Shares Fund is designed to provide both an enhanced level of income and total returns in line with its benchmark. The fund currently employs two active managers, Perennial Value Management and Ankura Capital, as well as investing in the Russell High Dividend Australian Shares ETF. All three are based on distinctive styles intended to provide greater income and price stability over a full market cycle. Over time, Russell will look to add to the manager line-up.

Mr. Lay said: “We have a high regard for the manager’s multi-manager investment process and the Australian-equities team, which has depth of experience, sufficient resources, and a solid performance track record. We have a similarly positive view on the portfolio manager directly responsible for the fund, Kathy Cave. However, the portfolio is still in a formative stage, with only two active managers, partly due to limited FUM, which restricts the ability to commission mandates tailored to the fund’s investment objectives. Our reservation is that the lack of strategic diversification may generate a level of income-volatility risk that compromises the ability to meet the needs of some of the targeted investor groups.”
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The funds affected by this announcement are:

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An Australian equity income focused fund will typically have an emphasis on: Level of overall yield Franking level Capital gains tax management.

Duncan Knight, Senior Investment Analyst, commented, “This sub-sector captures a range of funds, from ‘traditional’ imputation funds that typically target both a high level of franking as well as index outperformance, to more alternative funds that can use a wide variety of derivative strategies to focus on generating consistent income streams at reduced levels of capital volatility.”

In ascribing ratings to this sector, Lonsec recognises that operating an equity product with an objective of distributing income requires a different skill set than is required for managing a long-only large cap equity fund.

“Products in this universe need to have a multi-level assessment that will not necessarily be found in products with total return objectives,” said Knight.

“This can make like for like comparisons with other Australian equity products problematic.”

Sector themes and observations

Number of funds

“Although we didn‟t see many new products this year, a continuing trend is the diversity of styles and techniques in managing equity products with distribution objectives,” observed Knight.
“This is unlikely to slow in the near term, especially if the outlook for impaired global earnings flows to the Australian economy and in turn, negatively impacts corporate dividend payments.”

Traditional funds vs. Low beta funds

Lonsec believes the Australian equity income fund universe can be considered to comprise two distinct sub-sections—traditional income funds and low beta funds.

“Traditional funds are those which hold long-only positions in stocks, and distributions will typically be derived from company dividends, interest payments and capital gains from the same of profitable positions,” said Knight.

“Low beta funds will typically employ more diverse equity holdings and strategies than the traditional style products, in many cases the use of derivatives either as a source of income generation or a risk/exposure management technique.”

Such techniques can provide scope for fund managers to have a more diverse portfolio of underlying stocks. Understandably this can provide more robust capital returns through full economic cycles. Low beta funds generally have the flexibility to employ option strategies and other alternative measures to achieve their desired outcome.“Lonsec believes that, where appropriately managed, funds that are able to provide more consistent income streams that are paid to underlying investors are in an advantageous position by not relying completely on the domestic equity market,” commented Knight.

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