VALUE INVESTING
High Yield Beats Equity Income Funds

By Stephen Bland (TMFPyad)
December 19, 2003

My demo high yield portfolios (HYP) are intended for the income seeker or the growth seeker reinvesting dividends. I don't trade the shares, so it's an experiment to see how simply holding them for the very long term might work out. This is how I expect, and have seen, many investors actually hold shares in practice, whether for income or growth. I believe the do-nothing strategy is a fine one for a large number of investors. A lot of people operating the indolence approach will outperform those who try and trade the shares, in my opinion.

Although HYP1 is only about three years old it is useful to compare its performance against professionally managed funds. Funds are one clear alternative for those who wish to create income from equities either for growth or because they actually need the income. I wrote recently about the third anniversary of the portfolio and showed there that the growth including reinvested dividends was about 9.5%. I showed it this way for comparison because fund tables are also shown on a reinvested income basis.

Data from Trustnet shows that there were 89 Unit Trusts and OEICS in existence over the last three years in the sector entitled UK Equity Income. Their average growth was minus 5.4%. Of the 89, only 30 showed any positive growth at all.

However, the tables from Trustnet are based on a bid to bid basis. This is misleading because UT's have a bid-offer spread of around 5%, though OEICS operate single pricing. You can't in practice trade a fund with a spread on a bid to bid basis.

Okay, my HYPs have buying and selling costs too but nowhere near that amount. In fact the buying price of my HYPs includes all costs so I do not have to make any adjustment for that. The valuations I show are based on bid prices for the shares so that the only additional expenses upon selling would be the broker's commission. Call it say £300 for this, making the adjusted HYP1 performance a positive 9.1%.

Taking the adjusted 9.1% gain of HYP1, 19 funds from the 89 beat this but 9 have a spread and 10 are single-priced. Allowing for the spread where applicable, excludes a further four of the funds. That leaves 15 that beat HYP1 out of the total of 89. That isn't too bad really considering the charges that these funds have to bear. But it still means that HYP1 beat 74 of the funds, or 83% of them. I would naturally rather have seen it beat 100% of them but that is somewhat unlikely for a portfolio that is never traded.

An HYP that was traded by someone who knows what they are doing may well have done even better. However, that requirement - to know what you are doing – cuts out most small investors as well as the uninterested people at whom I aimed the indolence approach. A good lesson is that all those funds that failed to beat HYP1, as well as the small minority that did, would have been trading their shares which tells us something.

For comparison, UK index tracker funds, over the period taking the popular Legal & General fund as a benchmark, fell 21.4%. Thus even the average performance of equity income funds – which includes some real duds - was substantially ahead of the tracker. Both HYP1 and the better equity income funds make the tracker appear to be a poor performer and add weight to my long-held opinion that higher yielding shares are very likely to outperform the market over time.

Three years is too short a time to be able to appreciate how the really long-term situation, for which the strategy is intended, might turn out. But I still find it useful to compare the performance against what might be considered the competition, namely equity income and tracker funds.

The past three years have seen a substantial bear market followed by some recovery. That sort of scene is one where the high yield approach is going to especially effective, such shares being much more resilient to falling markets than shares in general. In rapidly rising markets, high yield strategies may well fall behind for a time. But in the long run I expect them to win by a wide margin, just as they have so far. And as far as equity income funds are concerned, I see little to suggest so far that they are a better proposition than a HYP.