What is the maximum level of
income which can be sustained
by an equity income fund?
By Rudi Minbatiwala, Senior Portfolio Manager, Australian Equities, Core
Colonial First State Global Asset Management
The stated objectives of the Colonial First State Wholesale Equity Income Fund (the Fund) are
designed to provide a balance between investors’ requirements for a greater level of cash flow
today and the provision of modest growth of their capital base in order to provide a growing
income stream over time.
The Fund’s stated objective is to deliver ‘expected annual income
of 2.5% above the S&P/ASX 100 dividend yield over rolling three
year periods’. Based on a long-run expected market dividend
yield of 4.5%, the Fund’s income objective is equivalent to 7%
per annum plus franking credit income (say, a total income
return of 8% per annum).
This raises an interesting question: What is the maximum level of
income which can be produced and sustained by an equity income
fund? In other words, what level of income can be paid before the
Fund effectively starts paying back clients their own capital?
One way of addressing this question is to consider an equivalent
concept relating to shares – the dividend payout ratio.
Dividend payout ratio =Percentage of earnings paid to
shareholders in dividends
= Annual dividends/annual net profit
= Dividend per share/earnings per share
Company directors determine an appropriate dividend payout
ratio that seeks to balance shareholders’ desire for both personal
income and the reinvestment of profits in the business in
order to grow earnings over time. Companies with modest
reinvestment requirements are able to pay a greater proportion
of earnings as dividends and, therefore, exhibit high dividend
payout ratios.
Investors should be concerned if a company’s dividend payout
ratio consistently exceeds 100%, ie pays dividends which exceed
profits over the long term, as this is clearly unsustainable. For
listed companies, maintaining a dividend payout ratio above
Adviser use only
100% can be achieved by either paying a ‘capital return’ or
frequently re-gearing the balance sheet. The most commonly
referenced examples of this approach include the former
Macquarie or Babcock & Brown listed fund models and highly
geared REITs, which fell heavily during the global financial crisis.
The income received from shares simply cannot exceed the
earnings generated by the firm on a sustainable basis over the
long term.
The income distribution return of a managed fund can be
considered the equivalent concept to the dividends paid by
shares of listed companies, while a fund’s annual total return
is the equivalent concept to a company’s net profit. Applying
the same payout ratio concept, investors should be concerned
if a fund’s ‘income payout ratio of total returns’ exceeds 100%
over the long term. Given that most funds do not use gearing, a
fund’s total return therefore limits the value of income that can
be distributed before managers are inefficiently drawing down
capital and, in effect, simply returning clients’ money back to
them. In short, a fund’s maximum sustainable level of income
return is the total return of the fund.
Given that share prices reflect a combination of a company’s net
profits and an earnings multiple, share prices (and, therefore,
equity fund total returns) will have greater variability over time
compared to company profits. As a result, the income payout
ratio for a fund will be more variable compared to a share’s
dividend payout ratio over time.
In order to determine the maximum sustainable level of income
return for an equity income fund, it is necessary to form a
view about the long-term expected total return that the fund
will generate.
The long-term expected total return for any Australian equities
fund consists of*:
1 Long-term Australian equity market accumulation index
return, plus
2 Franking credit income, plus
3 Expected alpha, less
4 Management costs
* Funds distribute taxable income. Therefore the level of total return and potential
distribution is pre-tax.
Source: Colonial First State Global Asset Management.
Most industry participants consider 8% per annum to be a
reasonable guide for the expected long-term return from
Australian equities. Therefore, for funds that simply invest in a
broad mix of Australian shares and capture this market exposure,
this 8% return is the maximum sustainable level of income return
that could be distributed over the long-term without simply
paying back capital.
In order to pay an income return above this 8% per annum level,
a fund must focus on the other two elements of total return.
The Colonial First State Wholesale Equity Income Fund employs
the proven stock selection process of the Australian Equities,
Core team that has delivered alpha of 2.84% per annum over
the 10 years to June 2010. This alpha is an important source
of additional total return and will allow the Colonial First State
Wholesale Equity Income Fund to pay a higher level of income
return to investors on a sustainable basis over time. Many
competitor funds in the equity income space modify their stock
selection process to focus on companies that pay a high level
of dividends. These funds may, therefore, be unable to realise
the alpha benefits that the managers’ underlying stock selection
process may provide.
Colonial First State Global Asset Management recently undertook
research on the benefits of franking credits. The research found
that market prices adjust for dividends and a large proportion
of franking value. It demonstrated that equity managers
should neither chase franking credits in the pursuit of income
nor ignore the value of franking credits. Rather, the research
suggested equity managers should develop systems that assist
in the capture of the franking credits by fulfilling all the ATO
requirements for claiming credits. The Australian Equities, Core
team has developed its investment process to maximise the
capture of franking credits and therefore further improve the
income return available to investors.
The active approach to income generation via the use of sold
equity call options (buy-write strategy) that is utilised by the
Colonial First State Wholesale Equity Income Fund and many of
its peers seeks to efficiently convert the total return generated
from the underlying share investments into a smoother income
stream over time. The options market is reasonably efficiently
priced. Therefore the expected return on an option will match
the expected return on the underlying asset. Evidence that the
option positions do not change the long-term expected returns
of the equity portfolio is shown by comparing the realised
returns of two series: the S&P 500 Total Return Index (SPXT) and
the S&P 500 Buy Write Index (BXM). Based on the daily long-term
data over the period from 1/1/1990 to 30/06/2010 the average
annual return of 9.1% on the Buy Write Index compares closely
to the average annual return of 9.3% on the Total Return Index.
We have used US data for this comparison as it has a longer term
track record but we have seen similar results in the Australian
market.
This paper has explained why the management of total return
should remain a fundamental concept for equity income funds.
Calculating the expected long-term total return from the
Colonial First State Wholesale Equity Income Fund enables us
to return to our original question – what is the maximum level
of income which can be produced and sustained by an equity
income fund?
Equity income return components
12%
10%
10%
10%
-1%
8%
8%
2%
1%
6%
4%
2%
0%
Long-term
Franking
Australian equity
credit
market accumulation income
index return
Expected
alpha
Management
costs
Total equity
Maximum
income fund
sustainable
return
income return
* Stylised concept chart.
Past performance is no indication of future performance.
The maximum level of sustainable income that can be paid
by an equity income fund over time is equivalent to the total
return generated after fees. The importance of alpha generation
should also be highlighted as an important factor that ensures
a higher level of income can be generated over the long term.
The stylised chart shows an extreme case whereby all the
total return is distributed as income. The Colonial First State
Wholesale Equity Income Fund objectives are to simultaneously
deliver a consistently high level of income each year and provide
conservative capital growth over time by reinvesting some of
the surplus total return. This reinvestment seeks to ensure that
the actual dollar value of the cashflow generated by the Fund
grows over time in order to maintain the purchasing power of
the income.
About the author
About Colonial First State
Rudi Minbatiwala is Senior Portfolio Manager in the Australian
Equities, Core team. He is responsible for the management of
the Enhanced Yield Fund and Equity Income Fund. This role
involves analysis of structured equities such as equity derivative
strategies and hybrid securities.
Colonial First State has been helping Australians with their
investment needs since 1988 and now has more than A$90
billion under management globally1.
Rudi has been part of the Australian Equities, Core team since
January 2000. During that time, his roles have included Portfolio
Manager for the index Australian equities portfolios, Senior
Quantitative Analyst for the Core active portfolios and Equity
Analyst covering the diversified financials sector and small
companies.
Our wide range of investment management expertise spans
Australian and global shares, property, fixed interest, credit,
infrastructure and resources.
We launched the Colonial First State Wholesale Equity Income
Fund in March 2008.
Rudi has a Bachelor of Commerce degree (Actuarial Studies) and
a Bachelor of Applied Finance from Macquarie University. Rudi is
also a CFA charterholder.
1 Colonial First State Investments Limited and its licenced related entities to which it has delegated investment or administrative functions.
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This document has been prepared by Colonial First State Investments Limited ABN 98 002 348 352, AFS Licence 232468 (Colonial First State). Colonial First State is a subsidiary of Commonwealth
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State. While all care has been taken in the preparation of this document (using sources believed to be reliable and accurate), to the maximum extent permitted by law, no person including
Colonial First State or the Bank (or its subsidiaries) accepts responsibility for any loss suffered by any person arising from reliance on this information. This document is general information only
does not take into account your individual objectives, financial situation or needs.
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