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Striking a balance
By Fiona Hamilton
Investors who fear it's too soon to plunge back into the UK stockmarket, but who want a reasonable income while they wait for the right moment, should consider the UK Equity & Bond sector.
To qualify for this sector, funds must have between 20% and 80% of their assets in equities, so they can capitalise on share prices when equities are doing well. But they must also hold between 20% and 80% in fixed interest. This means that they can also take refuge from equities, when necessary, in Government bonds (gilts) or corporate bonds. Corporate bonds involve more risk than gilts but offer a higher return, so they can be invaluable in helping achieve the sector classification authorities' requirement of a yield at least 20% higher than the FTSE All-Share.
Additionally, at least 80% of the fund's assets must be UK-listed; this reduces the currency risks but still allows managers to add some non-UK exposure if they see better prospects overseas.
Given the wide parameters, returns within the sector vary widely. Those funds that aim to have close to the maximum in equities should outperform in bull market conditions, but will be more vulnerable in bear markets. They are also liable to have a relatively modest yield. Jupiter High Income is a prime example. As the chart above shows, it did well from 2004 to mid-2007, then suffered an exceptionally tough 15 months. But it picked up again in late 2008 when equities rallied.
The fund's manager, Tony Nutt, has concentrated his equity holdings on large well-funded companies. But as he's worried about dividend cuts, he's considering boosting income by raising the fund's corporate bond exposure above its currently modest level of 26%.
"Equities are good value. Although there's a risk they could fall further, we can still find shares in many defensive growth companies with strong cash-flows," he says. "Many corporate bonds represent exceptional value. But investors should be aware that when inflationary concerns do resurface, bonds will fall out of favour."
F&C High Income is at the other end of the spectrum; it invariably has at least 60% in fixed interest and cash, and less than 40% in equities. One reason for this is that it aims to pay out a monthly dividend equal to bank base rate plus 2% or more, and bonds are a more reliable source of income. Also, a preponderance of bonds means its payouts (unlike equity dividends) are tax-free if the fund is held within an individual savings account wrapper.
Its modest equity exposure has meant the fund's total returns were well below average in the bull market, but it has been comparatively resilient in the last year, with a capital loss of 17%. But recent reductions in the base rate mean the fund has reduced its yield target for this year to just 3.5%, and this will be further reduced if there are deeper cuts. By contrast, its peers are likely to try harder to maintain their payouts.
Ecclesiastical Higher Income, meanwhile, seeks the best of both worlds by balancing between fixed interest and equities according to the outlook of its manager Robin Hepworth. Its equity exposure has been up as far as 75%. However, its cash and fixed-interest exposure is currently at an all-time peak of 65%.
"When I'm convinced things are getting better I'll raise my equity exposure," he says. "But for now, I'm still cautious. The equity market is better value than it was, but it has to be cheap before I start buying."
The fund has benefited from both Hepworth's strategic moves between asset classes and his stock selection, which has included a healthy dose of Far Eastern exposure Ð the proof is that it ended 2008 at the top of the sector over both five and seven years.
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