INVESTING FOR DIVIDENDS; THE POWER OF COMPOUNDING

When it comes to selecting building blocks for the construction of a diversified portfolio, equity income funds are worthy of investors’ attention. There are a number of ways to invest for income: cash (via a savings account), money market funds and bonds, to name a few. But equity income strategies can potentially offer higher returns than other income investments by accepting volatility associated with equity risk.

by Marina Gardiner

Essentially, the income element of an equity – if it has one - is its dividend, a sum paid out to investors at regular intervals, most commonly from net profits. For this reason, equity income companies tend to be high quality, well-established businesses with lower volatility than the wider market. In the thirty years between 1988 and 2018, half of all US equity market returns were accounted for by dividends.[1]

By contrast, a growth company will reinvest its profits by way of capital expenditure with the aim of returning value to investors by accelerating growth and increasing the overall share price. Over the longer term, investing this way is generally expected to deliver superior returns to equity income, but at the cost of higher volatility and greater risk.

Overall market climate matters, however, and in 2025, it turns out that the UK equity income sector outperformed the UK growth sector by almost 3%.[2] So investors were actually getting better returns for less risk. Unlike fixed income instruments with a set rate of interest or coupon and a nominal repayment value, which is vulnerable to the ravages of inflation, dividends and share capital have the potential to grow over time, helping to protect against inflation. And reinvesting dividends in turn allows for compounding, potentially boosting long-term capital growth. Not only that, but while the growth rate may be slower because a proportion of profits are being paid out, investors can potentially benefit from ‘double-barrelled returns’, both from the dividend and from a rising share price.

Equity income funds can define themselves by geography or set parameters relating to dividend yield or credit rating. Despite the old adage that past performance is no guide to future performance, a track record of regular payment of a consistent dividend matters to investors.  Regular dividend payers are sometimes referred to as “dividend aristocrats”.  But in this instance, what if there was a window onto future performance, that offered guidance as to a) whether a company was going to pay a dividend and b) the likely size of it? A significant proportion of those companies paying dividends, and certainly the larger ones, either publish a dividend policy, which provides a more general outline of future payouts, or issue forward-looking guidance which involves more specific dividend forecasts. The Elston UK Equity Income index comprises the UK’s largest dividend-paying companies, and is re-weighted each month according to forward-looking estimates. Over 1, 3, 5 and 10 years, on an annualised basis, the VT Munro UK Equity Income Fund which is benchmarked to it has outperformed its sector by up to 10.5%[3].
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Having an allocation to equity income in any diversified portfolio is a worthwhile consideration, especially so if the positioning of a fund is guided by estimated payouts. For the longer-term investor with an eye on risk, it shouldn’t be ignored.


[1] Fidelity International / Bloomberg

[2] IA UK Equity Income Sector vs IA UK All Companies (Growth) Sector

[3] Valu-Trac