Does equity income have any gas left?

Equity income investors have every reason to pat themselves on the back. While the stock market is tentatively recovering from several years of disappointing performance, equity income funds have been forging ahead.

For example, if you'd invested £1,000 in Jeremy Lang's Liontrust First Income fund this time last year, you would have been left with £1,334 by the end of December. And Liontrust is not alone: the other UK equity income funds have been basking in the glow of respectable returns. According to the ratings agency Standard & Poor's, the average fund in the sector grew by 18 per cent in the 12 months to 19 January this year, leaving equity income just behind the UK All Companies sector (20.8 per cent) and well ahead of the global growth sector (14.4 per cent) and UK corporate bonds (1.79 per cent).

Even more impressively, equity income has produced robust returns over the long term. During the 10 years to 19 January this year, the average fund in the sector grew by 84.8 per cent. If you had invested £1,000 in such a fund in 1994, you would now be sitting on £1,848.

This compares to average growth of 31.4 per cent for the global growth sector, 63.5 per cent for UK All Companies and 70.4 per cent for UK corporate bonds.

The annual report on income funds from portfolio manager Principal Investment Management, released last week, highlights some stellar performances, including that of Mr Lang's fund and of Rathbone Income and Newton Higher Income. All grew by at least 23 per cent.

But while these results have been impressive, many investors may be asking whether such growth can continue. "With 20 per cent [growth] last year, people might fear they've missed the boat - these things don't go on for ever," says David Holbrook, managing director of the independent financial adviser (IFA) Hallmark-ifa. "But if stock markets make steady progress this year, there should be continued dividend growth."

Equity income funds are often sold as a "core" or solid part of an investor's portfolio. Managers try to find shares that pay out healthy dividends to provide a decent income and offer some potential growth to your initial capital investment. On a risk scale, with building society deposit accounts at the safe end and specialist funds investing in emerging markets such as China at the other, Colin Jackson, director at IFA Baronworth, places equity income funds around the middle.

The funds allow you to make regular income withdrawals, paid every three or six months. Alternatively, you can ask for the income to be automatically reinvested in the fund.

At least 80 per cent of the fund's portfolio will be in domestic equities, and managers will aim to beat the average dividend yield of the FTSE All-Share sector by at least 10 per cent. To this end, typical stocks are likely to include companies in the oil, food, financial services and utility industries.

Nick Purves, manager of the Schroder Income fund, which has £545m under management, counts oil giant Shell and cigarette maker Imperial Tobacco among his top 10 holdings. "Equity income companies are seen as a bit dowdy," he says, "but over time they deliver growth rates with dividends that tend to outperform [other sectors]."

He admits, however, that there will be times when funds like his are out of favour. "In the late-1990s tech boom, people wanted exposure to growth companies that were going to deliver maximum capital appreciation," he continues. "But if you are saving for the long term - say 10 years - income funds will deliver returns above the FTSE All-Share."

As confidence seeps back into the market, and investors look for share price growth instead of dividend income, equity income funds could struggle to perform. But Mr Purves thinks that last year's stock market surge - fuelled by mid- and smaller-sized companies - has opened up other possibilities. "Steady growers like Allied Domecq, Cadbury and Unilever have been left behind and the market is underpricing them," he says. "Income will come from FTSE large-cap companies. In this environment, equity income will have a reasonably good 2004."

If you are already invested in an equity income fund, keep an eye on its performance. Don't buy one and then forget about it. Remember, too, that returns from equity income funds will be hit by the abolition of the 10 per cent tax credit on dividends from equity ISAs (see page 15).