You may have heard of equity income funds, but what exactly are they? The term is widely used both in Australia and internationally to describe a range of funds that share one common feature: they aim to generate income from investing in shares. This is what most share investment strategies aim for – to invest in companies that are profitable now or at some point in future, and then return these profits to shareholders through dividends and capital gains. However, should investors care whether they get profits through dividends or capital gains, or is it the total return that matters?

In reality, tax treatment does influence investor preferences. For example, dividends in Australia typically carry franking credits which are valuable to most Australian taxpayers, yet shares held for more than 12 months receive a capital gains tax discount when they are sold. This favours capital gains over dividends for individuals on top marginal tax rates. All else being equal, we would prefer $1 of capital gains over a $1 of fully franked dividends – particularly if we don’t have a current income need and shares are part of a long term retirement strategy. If the company can reinvest that $1 and turn it into $1.20 of capital gains, even better. However, for investors on lower marginal tax rates, including superannuation funds, $1 of franked dividends may be of greater after-tax value than $1 of long term capital gains.

Leaving aside the tax preferences, dividends can signal very important messages to investors:

Dividend signalling

When company management announces that they’re increasing dividends, this can signal that they’re more confident about the company’s future earnings. In contrast, companies that cut dividends are telling investors that profits are falling or that they need to preserve capital.

Capital management

Dividends can also show that management has a strong focus on capital management. Companies which pay out a large part of their earnings in the form of dividends are less inclined to hoard cash on their balance sheet or feel obliged to spend cash on acquisitions or marginal investments. This means their balance sheets can be structured with the optimal use of debt to enhance returns to shareholders. If additional capital is needed at the time of an investment or acquisition, it can be funded through a share issue or through a dividend reinvestment plan.

Franking

Franking credits built up at companies through payments of corporate taxes have no value until the company pays out dividends – at which time they become valuable to shareholders as tax credits, or even cash rebates. Therefore, companies that hoard franking credits and don’t pay out sufficient dividends are wasting or eroding the value of the franking credits.

Valuation

A share entitles its holder to receive dividends, capital upon winding up and to vote at shareholder meetings. Therefore, academic theory suggests the value of a share is really just the present value of its future cash flows – that is, future dividends.

Companies which don’t pay out stable and growing dividends – often because they are loss-making – become much harder to value and share prices tend to be more volatile (such as mining explorers, internet companies, etc).

A large part of total returns

Over long time horizons such as 10 years, studies have shown that dividends and franking credits have made up 60 percent of total shareholder returns.

Inflation hedge

Over time, corporate revenues, profits and dividends should keep pace with inflation. And in times of higher inflation, when companies increase the prices of their goods and services, dividends should rise more quickly.

Compounding and dollar-cost averaging

By reinvesting dividends back into companies through a dividend reinvestment plan – particularly relevant in a superannuation fund that’s in accumulation mode – dividends can be used to purchase additional shares (often at a small discount to market).

When share prices fall, dividends will buy more shares (like when dividend yields are high) and vice versa when the market is trading at high prices (such as low dividend yields).  Over time, this reinvestment and compounding of income means the final portfolio value should be higher than if dividends were simply placed in a bank account.

For these reasons, equity income funds or investment strategies that target dividend-paying companies should perform better over the longer term than broader equity investment strategies that simply target the highest growth stocks. However, a strategy focussed purely on dividend is unlikely to be successful over the longer term.

So, before investing in an equity income fund, understand how the portfolio is managed – is there a large exposure to particular sectors, such as banks or property trusts? What’s the degree to which future capital gains may be capped through option writing (if used)? What’s the level of franking and portfolio turnover which will impact the tax profile of the fund?

For further analysis, download the full report:

• Investment Strategy August 2014 (PDF, 98KB)