UK Equity Income fund managers are positioning their portfolios defensively, with many introducing bonds to make up the income shortfall from banks, says Standard & Poor’s Fund Services in a funds update.

“Their portfolios are mostly defensively positioned, focusing on large-caps with strong balance sheets and healthy cash flows,” said S&P Fund Services lead analyst Alison Cratchley, noting that this strategic positioning had already paid off for Neil Woodford, manager of the S&P Invesco Perpetual High Income Fund and Invesco Perpetual Income Fund in fourth quarter of 2008.

These returned 0.2 per cent and 0.1 per cent respectively, ranking top of the S&P Fund Services rated funds in the UK equity income sector and becoming the only funds in the sector to deliver positive returns. By comparison, the median UK equity income fund lost 7.5 per cent in the fourth quarter, against the 10.2 per cent loss on the FTSE All Share index and the 10 per cent loss on the median UK growth fund.

Mr Woodford continues to hold a bearish macroeconomic view. He believes the process of deleveraging taking place in the banking system and the consumer economy will take years, making the recession far more prolonged than the market expects.

Similarly, Brian Gallagher of the S&P UBS UK Equity Income Fund sees the economy still in the early stages of recession, with considerable risk to corporate earnings. Although valuations look attractive and there may be a series of short, sharp rallies during 2009, Mr Gallagher does not expect a sustained recovery in the market until the fourth quarter of this year and first quarter of 2010. He notes that, with many banks no longer paying dividends, some equity income managers are scrambling to deliver the income side of their proposition.

“Several managers comment that the income requirement is a challenge,” said Ms Cratchley, adding that some of the managers had reacted by introducing exposure to bonds. Michael Gifford, manager of the S&P Old Mutual Equity Income Fund has introduced a 5 per cent exposure to fixed interest, partly thinking that bonds will be defensive in the event of an equity market decline but also because they will make up the income shortfall left by the banks.

Other managers see opportunities in equities as sufficient. Nick McLeod-Clarke, manager of the S&P BlackRock UK Income Fund, says that the market fall has brought many traditionally low-yielding companies, such as BHP Billiton, into the income universe. Weak sterling has also helped, since many of the UK’s largest companies declare their dividends in dollars. Last year, he notes, Royal Dutch Shell raised its dividend by about 5 per cent in dollar terms but this was equivalent to a 30 per cent increase in sterling.

Standard & Poor's Fund Services provides qualitative fund research, including fund management ratings, on over 2,200 funds worldwide. These ratings are based on analysis of the stability of a fund's parent group, the appropriateness of its investment policy, and the sustainability of its performance.