Why invest in income funds (even when you don’t need income)

For those investors who are still focused on growing their wealth instead of spending, an income focused fund might intuitively seem like the wrong choice. However, despite the name, income funds can act as an important diversifier for a portfolio with a main goal of growth.

In this context, we aren’t talking about the version of a fund you choose, such as income (Inc) or accumulation (Acc) which you might see tagged on to the end of the funds in your portfolio. Those labels tell you if the version of the fund you chose will put dividends in your account or automatically reinvest them. Instead, we’re talking about funds designed to generate income, which specifically look for companies that pay a high or growing dividend to their investors. Income funds can invest in bonds or equities, but in this case, we will focus on funds with equity holdings.

What do income funds bring to the table?

These funds act as strong diversifiers in a portfolio not simply because they pay out an income, but because of the companies they target. Dividends are created through companies paying out a share of profits to investors. Therefore, stocks that pay out large dividends (therefore offering income to investors) tend to have different characteristics to the companies that dominate popular indices, like the S&P 500 or MSCI World.

These indices are currently heavily geared towards companies that are growing quickly. This includes tech names like Nvidia and Google, which are typically more interested in reinvesting their profits than distributing them to shareholders.

Companies traditionally associated with income funds tend to steer clear of those larger growth names, and instead lean towards well-established industries, such as energy, healthcare and financials. The growth (and growth of share price) for these businesses is often slower, but steadier with a larger element of the overall return coming from reinvested dividends. This can provide some needed stability to investors who hold index funds. You’ll recognise many of the companies these income funds hold as well, such as Barclays, BP, or Procter & Gamble (P&G). Companies that already pay big dividends can sometimes be at risk of cuts. For example, BP was forced to cut its dividend significantly in 2020 during Covid.

So, some income funds may invest in companies that have lower, but consistently growing, dividends instead. They aren’t as established as the BPs or P&Gs of the world, but they are still on a different path than the large growth names. In the UK, this includes companies like Games Workshop and Greggs which have grown their dividends in the past five years by over 28% and 63%, respectively. The benefit of these investments can be the growth in dividends overtime, and getting involved while the dividends are smaller can lead to attractive returns in the long run.

Just because a company offers a dividend doesn’t mean it’s automatically a good investment. Investors and fund managers need to stay alert to ‘dividend traps’. These are companies which often have poor balance sheets and offer too-good-to-be-true dividends in a bid to entice some investors, adding risk rather than creating stability. After all, the dividend yield is simply the current share price divided by the last 12m dividend and if the share price has fallen back, the yield will potentially be artificially high.

The power of reinvested income

Dividends are likely a large part of your portfolio return already, even if you aren’t aware of it. In the past 20 years, the price of the MSCI World in pounds has increased by 372% to 12 May. But the total return of the MSCI World, which includes dividend payments that have been reinvested in the market, is 585%. Einstein is popularly quoted as saying that investing is the “eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”

In a fund that is specifically focussed on stocks with high levels of income, reinvesting dividends becomes more important, because it will account for an even larger portion of the return. Many funds will have an option to do this automatically, through an accumulation (Acc) version. But not all funds will have this option, such as investment trusts. In this case, you’ll need to be responsible for reinvesting the income to your account to get the most out of your fund. Most income funds pay a dividend at set times throughout the year. You can set up a reminder in your diary for these dates to go back into your account and feed the income back into your funds.

Choosing an income fund

Some income funds will put the name right on the tin, but others make you work a bit harder to understand if that’s what they are offering. One way to sniff out income fund options is through searching by level of yield. You can do this on the AJ Bell fund screener, in its advanced options. Higher yielding funds will have a larger income focus.

Depending on your goals as an investor, you can look for funds with companies that already have high dividend yields, or you can look for those growing yields from companies like Greggs that we saw earlier. The benefit of these companies is that they are less likely to be at the stagnation stage than companies with already robust dividends.

Funds will often note this on their factsheets by using phrases like ‘dividend growth’ or ‘dividend appreciation’. If you would rather hold your funds in an investment trust, the Association of Investment Companies keeps a list of every trust that has grown its dividend consistently over the past 20 years, which they call dividend heroes.

In the past, income-focused funds have mostly been managed by financial professionals, or in other words are actively managed, rather than tracking an index. But now, there are a variety of tracker fund options that focus on income. Smart-beta funds can be used to gear fund allocation towards a specific factor, instead of being based primarily on market cap like most indices are. These typically come with a lower fee than their active counterparts.

Here are a few of the income funds which are part of AJ Bell’s Favourite funds and Investment Trust Select lists. The versions linked here are income funds, but all except City of London have accumulation versions as it is an investment trust.