It's been a year of extremes. From the optimism of the first quarter, when the Dow and the S&P 500 were up 7.1% and 5.9% respectively, to the debt-ceiling standoff and the sovereign debt crisis in Europe that drove those same indexes down 11.5% and nearly 14% during the third quarter, equity investors have been scrambling to figure out their next moves.

The result of this global political and financial turmoil has been jarring increases in volatility. Daily stock price index movements of 1% or more to the upside or downside, shifts of 4% in a 30-minute trading window—these events have left many investors with a desire for a sense of stability. Equity-income funds may provide some of that stability.

Lipper defines equity-income funds as those funds that seek relatively high current income and income growth through a substantial allocation in equity securities—stocks that include warrants, rights and options. The current benefit of this type of investment is volatility management through steady income generation.

But steady income streams are not the only factor investors and advisors have looked at when trying to sort out portfolio allocations. Recent developments in the bond and equity markets have forced investors to rethink their basic sources of income.

Historically low borrowing rates, along with increased demand from shareholders for dividend income, have forced the yields of stocks and bonds to converge over the last four years. With 10-year Treasury rates hovering around 2%, similarly yielding stocks have become more attractive to investors.

Looking at the funds themselves, at the end of the third quarter in 2007, the average 12-month yield of equity income funds was around 1.7%, compared with general U.S. Treasury products at 3.4%. For the same period this year, the values have shifted. Equity-income funds now yield 2.1% on average as opposed to general U.S. Treasury products at 1.9%.

That said, the values of equity-income funds have not been immune from the market downturn. In fact, equity-income funds have lost 8% on average total return this year as of the end of the third quarter. But, comparing this to the average total return of all U.S. diversified equity funds over the same time period (12.2%), equity-income funds seem to be weathering the storm better.

This is in part due to the nature of total return, which assumes 100% reinvestment of distributions. It is their distribution stream that helps equity-income funds stand apart from investments that rely solely on capital appreciation for their returns. And, although equity-income funds are often looked upon as being too conservative (they don't keep pace during the rallies), they have outperformed the average U.S. diversified equity fund by 20 basis points over the last 10 years: 3.94% versus 3.74%.

So with attractive yields and decent relative returns in this market environment, one would assume investors would be gravitating toward equity-income funds. Looking at sales of these funds so far this year through the end of the third quarter, this appears to be exactly what's happening in the sector.

Most domestic equity funds are seeing investors rushing to sell. In fact, they suffered roughly $75 billion of net outflows through the end of the third quarter.

Equity-income funds, meanwhile, have attracted some $16 billion of net new assets. This amounts to roughly 12% of the group's total assets as of the beginning of the year and outpaces all of its combined inflows over the previous five years.

Overall, equity-income funds currently have attractive yields, and have provided decent relative returns over time. But, as with any investment, there are risks involved with these products. Compared with obtaining yields through bonds, portfolio managers must risk more principal when investing in stocks. After all, one frequently overlooked reason that equity yields have increased is that the underlying values of the stocks themselves have fallen.

This brings up another risk of investing in stock funds: Investors, by definition, put their faith in a portfolio manager to choose dividend-paying securities based not only on yields, but also on a given company's projected ability to distribute that income. But in the end, if the product's risk profile and the investor's risk tolerance align, equity-income funds may be a strong fit for long-term investors seeking to benefit from consistent income.

 

Matthew Lemieux is a research analyst for Lipper,
where he specializes in performance analysis,
methodology management and fund flows.
He is a regular contributor to the Lipper FundFlows Insight
reports and the weekly video series.