The £1.2 billion Rathbone Income fund is to be thrown out of the UK Equity Income sector in May, having become the latest victim of the problematic rules governing income funds.

This comes hot on the heels of yesterday’s news that the Investment Association is consulting on changes to the sector definition to prevent expulsions like this happening. Carl Stick of Rathbones joins a growing number of managers who have been exiled from the UK Equity Income sector. He is in good company; Mark Barnett of Invesco Perpetual and Kevin Murphy and Nick Kirrage of Schroders have also been banished to the UK All Companies sector, along with a number of other managers. 

Laith Khalaf, Senior Analyst, Hargreaves Lansdown: ‘Another fund bites the dust from the UK Equity Income sector, in a timely demonstration of why the rules need to be reformed.

The Rathbone Income fund is in our view one of the best funds in the sector. We won’t be amending our analysis or view of the fund manager in light of the change in sectors, and the fund will remain on our Wealth 150 Plus list of our favourite funds available with low management charges. 

The Investment Association is taking matters in hand and consulting on the issue which is pushing funds out of the UK Equity Income sector, though we don’t believe any of the proposals tabled so far solve the problem. Any solution needs to make sure it doesn’t impose any additional burden on investors when choosing funds, and should also ensure investors are getting a healthy income premium to the market over the long term.’ £19 billion of income funds currently sit in the UK All Companies sector, after being exiled from the UK Equity Income sector for not having produced sufficient income under the present rules. 

The £19 billion is mainly made up of Invesco Perpetual’s income range, currently managed by Mark Barnett (formerly by Neil Woodford), but it also includes the Schroder Income fund and Jupiter Responsible Income fund. A fund’s qualification for the UK Equity Income sector is based on the fund maintaining an average yield of 10 percent more than the FTSE All Share over a three year period, and not falling below 90 percent of the FTSE All Share yield over any twelve month period. However this test is currently calculated using a historic yield – taking the income produced during the year as a percentage of the price of the fund at the end of the year. 

But if a fund manager has done a good job of increasing the fund’s capital, and hence its price, this has the effect of lowering the yield, and boosting the chances of the fund getting kicked out of the sector. 

Fund A starts the year at a price of £1 per unit and ends the year at £1.10 per unit, producing an income of 5p over the year. The historic yield of the fund is therefore calculated as 4.55 percent (5p/110p). Fund B starts the year at a price of £1 per unit and ends the year at £0.90 per unit, producing an income of 5p over the year. The historic yield of the fund is calculated as 5.56 percent (5p/90p). Both funds have provided the same amount of income to investors, but fund A has done a much better job of growing capital. However under current rules, Fund A also has a much better chance of being thrown out of the UK Equity Income sector. 

The IA is putting forward three options for the sector. The first is that no change is made to the sector definitions. We view this approach as untenable seeing as there is such widespread recognition that something is seriously awry with the current rules. The second is to lower the bar and simply require funds to produce more income than the FTSE All-Share. We believe this doesn’t do enough to ensure investors are getting more income than the index could provide. On this basis a FTSE 100 tracker would probably have sufficient yield to sit in the sector. The third option being considered is to force funds to produce more in-depth income statistics. While these would no doubt be useful for some, most investors don’t want reams of numbers thrown at them when choosing to invest. This proposal simply pushes the problem onto investor’s shoulders, which simply isn’t fair. Investors in UK Equity Income funds just want to know their fund is aiming to provide a premium level of income, and is achieving that goal. 

Our proposal would be to consider calculating the yield based on the income produced for each £1 invested at the start of the period. So in the above example, both funds are allocated a yield for the year of 5 percent (5p/100p), and therefore stand the same chance of staying in the sector based on the income they have produced. The aim is not to weed out underperforming funds, but to make sure that income funds which grow capital aren’t as disadvantaged when it comes to staying in the sector as they are now; the sector rankings will then speak for themselves in terms of overall performance.