How to remain exposed to equities while being mindful of the downside risk

The year may have hardly got going, but 2017 has already seen the UK stock market hit new highs – and, inevitably, warnings that this strength may not be sustainable given the economic uncertainties that lie ahead. For stock market investors, that raises a familiar quandary – how to remain exposed to the potential upside of equities while being mindful of the downside risk.

Advisers may have a number of different answers to this problem, but one strategy that looks set to remain in favour this year is a bias towards income-producing stocks. For one thing, generous dividend payers provide some compensation even if the capital value of their shares falls back. For another, such stocks will continue to be prized by income-seeking investors, who have precious few options in the hunt for yield; the US may have moved back towards a climate of rising interest rates, but the UK does not look ready to follow suit.

Income-focused investment companies are well placed to provide investors with exposure to a strategy built on high yield. Not only do their underlying portfolios consist of stocks offering good dividends, but also their own dividend records make them attractive in their own right.

The “dividend heroes” of the investment company sector are now well-known – some 20 closed-ended funds have raised their dividend in each of the past 20 years, including 10 funds that have done so in each of the past 40+ years. But beyond these stand-out performers are a host of additional investment companies with a consistent long-term track record of maintaining and increasing dividend pay-outs.

Crucially, one reason investment companies have been able to achieve such good results is unique to the closed-ended fund sector. Unlike other collective investment vehicles, investment companies are allowed to keep back some of the dividend income they earn in bumper years for pay-outs in order to fund payments to their own shareholders in less good times. They even have the option of making dividend payments from capital, with shareholder approval.

It is this structural nuance that ensures investment companies have the ability to go on maintaining and raising dividends, year after year, even when the income they receive on their underlying portfolios takes a dip.

That could prove particularly important in 2017, amid speculation that dividend payments from the UK market as a whole may fall back on the sums paid last year and in 2015. Difficult trading environments in sectors such as food and financial services have prompted warnings that previous levels of dividends may not be sustainable.

The broader point, however, is that whether investors are looking for income or simply a safer haven during a potentially volatile period for equities, income-focused investment companies could be an interesting option. Indeed, that may even include investment companies finanrom outside of the income sectors – it was interesting to note, for example, the 40 per cent dividend increase announced by Scottish Investment Trust last week.

Such funds have certainly been in demand in recent times, with shares in many trading at a premium to the value of their assets over large chunks of 2016. There is good reason to expect that to continue over the year ahead, as income funds attract income seekers and nervous investors alike.