Merchants (MRCH ) and Dunedin Income Growth (DIG ) were unable to keep up with a long-awaited recovery last year.

Net asset value (NAV) returns of 9% from Dunedin and 12.4% from Merchants would previously have been applauded by shareholders. However, over the 12 months to the end of January these gains were not enough to beat a 17.1% rise by the FTSE All Share.

The stalwart trusts of the UK equity income sector – both of which have been running since the late 1800s – struggled to keep pace with the UK rally, as neither Merchants’ value style nor Dunedin’s quality growth strategy delivered.

Aberdeen’s Ben Ritchie and Rebecca Maclean, managers of the £367m Dunedin portfolio, said in annual results that the trust lagged the index on account of its historically large underweight to the banking sector, which rallied following interest rate cuts last year.

They said their focus on ‘quality’ stocks means banks are largely excluded due to the sector’s ‘significant economic sensitivity and exposure to political and regulatory oversight’. The managers also pointed to the banking sector’s ‘poor track record of maintaining and growing dividends’.

However, banks have recovered from Covid lows. Higher interest rates have supported net interest income growth, and ‘modest valuations’ all drove shares higher.

The managers acknowledged that not including the biggest banks was a ‘missed opportunity’. Ultimately, they added Natwest (NWG) over the period to ‘better balance’ their financials exposure.

‘NatWest is a relatively simple banking operation, generates robust returns, has an improving revenue outlook, and offers a well above-market dividend yield, supported by a strong balance sheet, which gives us greater confidence in its long-term sustainability,’ said Ritchie and Maclean.

Allianz Global Investors’ Simon Gergel, manager of the £784m Merchants portfolio, had a ‘reasonably large’ exposure to banks. Although banks posted generally strong gains, in annual results released last week he said the winners were overshadowed by the legacy issues relating to commissions from motor finance policies.

Close Brothers (CBG) was the hardest hit, but both Lloyds (LLOY) and Bank of Ireland had exposure to motor finance, causing their shares to lag the sector materially, the fund manager acknowledged.

‘We believe that share prices overreacted to the issue, but to put it into perspective, Natwest and Barclays’ (BARC) shares had a total return of over 100% but Lloyds was “only” up about 55%,’ said Gergel.

‘A 50% performance gap between Natwest and Lloyds is highly unusual. Close Brothers was particularly affected and lost just over 40% of its value.’

Gergel described Close Brothers as ‘one of the most disappointing holdings…in recent years’, which warranted ‘some soul searching on our part’.

However, he has added to this position ‘at very depressed prices’. He doesn’t view this as doubling down on a mistake or holding on out of pure stubbornness, but ‘recognising the value on offer at this point while accepting that the facts have changed’.

‘We have conviction that our modest position in Close Brothers can deliver a good return from here, offsetting some of the disappointing performance of this investment case in the past two financial years,’ he said.

Over the past three years, Dunedin Income Growth’s shares are up 8.6% which compares to a 16.5% gain by the average trust in the AIC’s UK equity income sector. The 5%-yielder currently trades on a 7.8% discount.

Meanwhile, Merchants’ shares are up 3.1% over three years, far behind 16.5% by peers. It currently yields 5.5% and trades on a 2.4% discount.