for equities

He may only have been in the job for just over six months, but Mark Carney, the Governor of the Bank of England, has already signalled his intention to do things differently and this is most noticeable in his concept of ‘forward guidance’.

Ongoing problem in the UK’s productivity levels

In the past, the Monetary Policy Committee minutes focused their thoughts on the current situation for the economy, the dangers for inflation and their plans for interest rates. However, Mark Carney has added in a commitment (albeit with a few caveats) that they won’t even consider increasing interest rates until unemployment drops below 7%. This is designed to help the Bank address an ongoing problem in the UK’s productivity levels, which appear to be well behind those of other developed economies.

An investor’s point of view

However, from an investor’s point of view, the consequences of this promise might be somewhat stark. Based on the Bank’s projections, it looks like rates could stay where they are until the third quarter of 2016 at the earliest. That said, these things are never quite as simple as they appear – and in this case, the market doesn’t appear to agree with the Bank. The UK’s borrowing costs continue to rise and many traders are predicting that rates will actually go up in late 2015.

Funding for long-term growth

There are now some indications the Bank may use quantitative easing to bring the market in line, but even if it doesn’t, investors could be facing two years of rock-bottom income from their cash investments. As a result, many are being forced to look further afield for a higher income and are discovering the benefits of equity income funds. These are funds that invest in established companies paying regular dividends. Investors can choose to have this income paid directly to them or reinvest it back into the fund for long-term growth.

Achieving a decent income

It’s easy to see the appeal of equity income in this environment. Equities are the only major asset class that has managed to increase its yields over the six years since the financial crisis started[1]. In addition, UK equities towards the latter part of 2013 were yielding 3.7%, which is significantly more than cash and UK government bonds did[2]. It is important to remember that this is not guaranteed and past performance is not a guide to the future.

Higher-yielding shares

Of course, the current market situation isn’t the only reason to choose a fund that focuses on higher-yielding shares. For a start, these shares actually tend to outperform lower yielding stocks over the years[3] – and their prices don’t tend to fluctuate in value as much. In part, this performance may be down to the dividends themselves. Companies don’t like to cut their dividends, so even if their share price is falling, they will try to maintain (or even increase) their payments, which helps protect an investor’s total returns.

Helping the share price rise again

What’s more, when the share prices of these companies fall, their yield (the dividend they pay, expressed as a percentage of the share price) goes up. A high dividend yield that is seen as sustainable can attract more investors and this interest may then help the share price rise again. It’s also the case that dividends are normally paid by larger companies and these businesses tend to be comparatively lower risk.

An option for long-term growth

When the income payments are reinvested, they provide investors with a second source of returns. Over the long term, compound growth can magnify these returns dramatically – nearly 60% of the total return from UK equities can be attributed to the reinvestment of dividends over the past 25 years[4].

Accessing this potential

There are two main types of equity income fund. Some focus on the UK, which has a long established dividend culture, while others aim to benefit from the greater opportunities offered by a global approach (as a rule, the global funds are considered riskier than the UK-focused ones).

Looking ahead

The start of 2014 could be a good time for investors to explore new options, particularly as inflation will be silently eroding the value of their savings if they leave their money in cash. Equity income funds could give you a steadier ride, while the dividend payments have the scope to provide an income or help boost returns through all conditions.

Source:
[1] Datastream 30.09.13
[2] Datastream 09.10.13
[3] Citigroup 30.09.13 in US$
[4] Datastream 01.09.88 to 30.08.13 based on the FTSE All-Share Index
Past performance is not necessarily a guide to the future. The value of investments and the income from them can fall as well as rise as a result of market and currency fluctuations and you may not get back the amount originally invested. Tax assumptions are subject to statutory change and the value of tax relief (if any) will depend upon your individual circumstances.