The Evolution and Benefits of Equity Income Funds in Australia’s Growing Retirement Market

Australia’s growing retirement-age population has seen an increase in demand for and the availability of equity income funds over the last few decades. Australia’s unique dividend imputation system means investors can successfully derive meaningful income as well as capital growth from holding Australian equities. Equity income strategies regularly make up a large component of the equity allocation for income-focused clients who seek a more defensive asset mix.

Equity income funds have evolved significantly over time, beginning in the 1990s, with MLC and Colonial First State (now First Sentier Investors) launching equity income products. These initial products were not specifically focused on paying a regular, smoothed, tax-effective income but rather designed to grow capital before retirement to provide income once in retirement. The mid-2000s saw the equity income fund reimagined, designed specifically to meet retiree’s key objectives – income generation, volatility management and capital growth over time. A number of managers developed products to meet these objectives at this time.

The wake of the GFC saw growing recognition of the importance of total return generation from income, limiting the need to sell down holdings during market downturns. As a result, the equity income space continued to grow and through the 2010s, various managers launched new income funds, often with full market exposure. Additionally, with the rising popularity in passive investing through the 2010s, income-focused ETFs also emerged from leading ETF providers with the goal of generating income that exceeds the dividend yield offered by the broader market. With an aging population, the addressable market for equity income funds is only growing. Whilst not all equity income funds remain in existence today, there are a variety to choose from with over 15 Australian fund managers offering a product in this space.

The need for regular income in retirement is well known and there are various ways to meet cashflow requirements. However, many of these tend to overlook the particularities of retirement. While fixed income products can help to meet an income objective, they fail to provide capital growth to protect against the impacts of inflation. A diminishing capital value on a real basis is inconsistent with the desire of many retirees for a growing capital base for both peace of mind and to leave an inheritance. Another option is to pursue an equity strategy centred solely on capital growth and simply selling down holdings when cashflow is required, rather than investing in income-generating investments. Yet, this ignores the fact that retirees are much more impacted by periods of drawdown than other investors, especially early in their retirement, amplified by their obligation to draw out from accounts when in pension phase. The GFC market crash and COVID-19 selloff in early 2020 demonstrated the serious consequences of needing to sell at an inopportune time and its long-term impact on total return. Skewing the components of equity total return to income removes the need to sell investments to raise cash when required. Proposed alternatives to equity income also ignore the value of franked dividends, which for retirees in pension phase present significantly more value than unfranked income or capital gains. Australian equity income strategies, when structured and executed appropriately, can provide strong total returns over time through attractive dividend yields and without sacrificing capital growth.

The Merlon Australian Share Income Fund was launched in 2005 and led the innovation of contemporary equity income funds. It was the first product of its kind, aiming to provide above-market income with franking, grow capital over time with lower risk than the market. The non-benchmark portfolio has a high active share, blending well with both passive and direct share portfolios which are typically overweight large cap stocks. The Fund delivers above market income, the majority from franked dividends, paid monthly and has demonstrated strong risk-adjusted returns over multiple time periods. The strategy features a risk reduction overlay to insulate the Fund during periods of drawdown whilst retaining 100% of the franked dividend income generated from the underlying portfolio.

Merlon’s investment philosophy is based on the idea that behavioural biases create opportunities, even in markets considered “efficient”. In particular, Merlon focuses on investing in companies where the market has become overly pessimistic, investing in undervalued companies with a focus on downside/bear case valuation to preserve capital. Merlon believes that buying companies when the market is overly pessimistic at low end of valuation range should result in growth of the capital base. Companies are valued on the basis of sustainable free cash flow, not dividend yield alone which is often a poor indicator of future performance and can lead to destruction of capital value. History has shown that investing in quality companies with sustainable free cash flow leads to higher dividends throughout the cycle and attractive total return.

This material has been prepared by Merlon Capital Partners Pty Ltd (ABN 94 140 833 683 AFSL 343 753) (Merlon), the investment manager of The Merlon Australian Share Income Fund (Fund).  Fidante Partners Limited ABN 94 002 835 592 AFSL 234668 | Fidante Partners Services Limited ABN 44 119 605 373 AFSL 320505] (Fidante) is a member of the Challenger Limited group of companies (Challenger Group) and is the responsible entity of the Fund. Other than information which is identified as sourced from Fidante in relation to the Fund, Fidante is not responsible for the information in this material, including any statements of opinion.It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable to your circumstances. The Fund’s Target Market Determination and Product Disclosure Statement (PDS) available at www.fidante.com should be considered before making a decision about whether to buy or hold units in the Fund. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.  Past performance is not a reliable indicator of future performance. Merlon and Fidante have entered into arrangements in connection with the distribution and administration of financial products to which this material relates. In connection with those arrangements, Merlon and Fidante may receive remuneration or other benefits in respect of financial services provided by the parties. Investments in the Fund are subject to investment risk, including possible delays in repayment and loss of income or principal invested. Accordingly, the performance, the repayment of capital or any particular rate of return on your investments are not guaranteed by any member of the Challenger Group.