What are equity income funds?

When you're new to investing, you encounter a lot of jargon. This is especially the case where investment funds are concerned – which is ironic, since funds are meant to simplify life for investors.

In particular, you will hear about equity income funds. Several of the UK's largest funds are of this type, and they are often suggested as the cornerstone of your portfolio.

However, if you're unfamiliar with the terminology, it's not immediately clear what they do.

This guide sets out to explain what equity income funds are, how they aim to make money for investors, why they are popular, and where to find them.

What is an equity income fund?

An equity income fund is a collective investment (fund) that holds shares (equities) that pay you an above-average dividend (income).

Let's break this down – skip any parts you already know.

Equities – and how they provide investors with a return

Shares are also known as equities, because each share represents a portion of equity in the company that issues them.

London Stock Exchange, where most UK shares are traded

Shares offer ordinary investors two principal ways to grow their money:

  • Capital growth – the shares go up in value (i.e. you are able to sell them for a higher price than you paid for them)
  • Income – you receive dividends (i.e. you get a share of the company's profits), which can either be drawn down, left in your account as cash, or reinvested.

These both contribute to your total return – i.e. the amount you theoretically earn from your investment, taking into account capital growth and income received, over a given period of time. (Bear in mind it's possible for total return to be negative).

Now, capital growth gets a lot of press. Much of the discussion around the benefits of owning shares focuses simplistically on rises or falls in a company's share price. Share indexes measure only share price movements; their rises and falls are also widely reported. Therefore the appeal of shares to many investors is the hope to “buy low, sell high”.

However, as we shall see, much of the long-term benefit of share ownership comes through accumulating, and then reinvesting, dividend income. The next section explains why this matters.

Income – and two ways to use it

Income from shares comes in the form of dividends paid out to shareholders; this is known as equity income.

Detail of dividend income transactions

Dividend payments received in a stocks & shares ISA

Not all shares pay dividends. But those that do provide one of the more historically reliable ways to make a return on your investment.

Like capital gains, dividends are not guaranteed. A share that has paid a dividend in the past might reduce or cancel it in the future.

However, once a dividend is paid to you, it is your money. In other words, it's a tangible return, not an “on paper” gain that could be taken away by market movements.

Therefore dividends (equity income) can be useful to investors in two ways.

  • You can have them paid out to you right away

    When a dividend is paid to you, it arrives as cash and will sit in your investment account awaiting your instructions. Some investors choose to have this paid out to them straight away. This is understandably popular with retired investors, who may choose to leave their capital invested and draw on the income for living costs.
  • Or you can reinvest them, in order to earn more dividends

    This means the money received from dividends on the shares you hold is used to buy more shares, which means you can receive more dividends in the future. This allows you to harness the power of compound returns; the longer you stay invested, the more it can benefit you.

This second way – reinvesting dividends – is key to understanding the potential of equity income funds to grow your wealth over time.

At first it might not be apparent why equity income is relevant to investors looking for long term growth – i.e. those who don't need or intend to draw a regular income from their investments. However, when you understand the effect of compounding (we have an illustration here, and we're working on a more comprehensive guide to explain it fully), it becomes clear that investors looking for long-term capital growth could benefit from looking not only at “growth shares” – those that may increase in price – but shares that will provide a reliable dividend that you can reinvest over the years.

At this point you may be wondering how to select this kind of shares.

This brings us to the “fund” part.

Funds – and how they help you access equity income

Funds that look to invest primarily in shares that will pay a reliable dividend are called equity income funds

The breakdown of investments held within a fund

Breakdown of a UK equity income fund's top holdings

When you're looking to invest in shares, there are essentially two ways to acquire them.

  1. Directly – select the shares yourself and buy them individually

    If you are willing to do your own research – and there are tools online that can help with this – it's possible to open an ISA, SIPP or general investment account and start buying individual shares to build your portfolio.

    Ordinary investors might find two drawbacks to this approach. The first is that there's no economies of scale. You pay dealing costs on each trade you make, so unless you're investing large sums, these costs can bite off a significant part of your initial investment. The second is that it is harder to diversify. If you want to build a diversified portolio – reducing your risk by holding a variety of different types of shares – this means multiplying your research efforts and dealing costs.
  2. Through a fund – buy units in a fund that seeks out the type of shares you're interested in

    A fund is essentially a professionally managed pool of investors' money that is invested in a range of holdings. The fund manager uses their research and expertise to choose shares that, in the case of equity income, are expected to pay a progressive and reliable dividend over time.

    You invest in the fund by buying units. The unit price changes according to the value of the fund and its holdings, after charges. Therefore you benefit in proportion to the number of units you hold. Dividends can be either paid out to investors in the same way as shares (if you hold income units), or rolled up, i.e. reinvested in the fund and reflected in the price of the units (if you hold accumulation units).

It's easy to see why many investors prefer to invest through a fund. A well-managed fund comes with the appeal of a ready-made portfolio, out-of-the-box diversification, straightforward pricing and the fact you are essentially outsourcing the day-to-day decisions to a professional investor.

However, a poorly managed fund will still take its charges whether the underlying investments perform well or not.

Therefore, your job is to choose a good equity income fund manager.

Where to find equity income funds

The investment platform Hargreaves Lansdown offers, at the last count, 183 different funds classified as equity income funds. (As mentioned earlier, it's a popular sector).

The largest equity income fund in the UK at the time of writing (and the third largest overall) is Invesco Perpetual High Income, managed by Mark Barnett. This is a classic equity income fund, focusing on UK income-paying shares. For many years the fund manager was Neil Woodford; he has since set up his own fund management company and launched his own equity income fund, the CF Woodford Equity Income Fund.

You don't necessarily have to look at funds that fall within the tightly-controlled Investment Association UK Equity Income or Global Equity Income sectors – which require (among other things) 80% of the fund to be invested in shares – in order to find a good equity income fund. For example, Richard Hughes manages the M&G Extra Income Sterling fund, which at the time of writing is invested 73% in equities. Richard is the first manager to achieve 47 months consecutive Citywire AAA rating – not a bad fund to have been invested in for equity income over the last four year.

This is not a recommendation of where to invest. When you're looking at the track record for different funds, please remember that past performance is not a reliable guide to future returns. What matters is the future – in other words, which investments the fund manager is choosing now, and how strongly you believe these will prove to be good investments over the timescale you're considering.

Where we can help is in deciding which platform you might want to use to buy these funds.

We've built a platform comparison tool to help you estimate which investment platforms will offer you the best combination of features and charges for the style, and amount, you intend to invest. Some of these platforms provide you with their own research on funds, and tools to help you screen and choose fund managers. Others repurpose data from sites like Trustnet and Morningstar, which can be useful research destinations in their own right.

Take a look now, if you are decided on choosing funds or shares for yourself:

Compare investment platforms

Alternatively, if you are right at the beginning of your investment journey and are wondering what type of investment could be right for you, please head over to our investment options tool to work through a Q&A on your choices.

Last updated: 26 May 2016