‘(UK income funds) prioritise dividends over any other kind of return from a company and therefore by definition penalise growth.’ This powerful statement is from an article by Paul Marshall from asset manager Marshall Wace. Published in the Financial Times, it has stirred a debate on whether investors should look more closely at how funds generate income.

A typical income fund will invest in a company that is generating a lot of cash which is mostly paid out as dividends. That is an attractive proposition for many investors, particularly those in retirement who rely on their investments to replace part of the salary they enjoyed during their working life.

Marshall says while UK income fund managers are trying to protect the income of pensioners, their strategy leads to investing in companies which might lose out longer term by handing out cash rather than investing it back in the business. ‘This is a form of financial decadence, discouraging capital investment and stifling growth and productivity,’ he adds.

One problem with the UK market is that many of its largest companies are growing very slowly or have highly cyclical earnings. They’ve already conquered their industries and perhaps lack inspiration to try new things or improve efficiency.

They are generating cash but, in Marshall’s view, are thinking about dividends first and then seeing what else they can do with any money left over. A cynic might say they are so focused on dividends as it is a way of keeping investors interested in their stock.

Cash should only be paid out if a business has no other use for that money, and the pandemic might have acted as the catalyst for boardrooms to rethink their capital allocation priorities. We’ve already seen a lot of companies rebase their dividends at a lower level and the consensus among income fund managers is that this was a good move as it helps make dividends more sustainable. It has also led some companies to think more about reducing debt to better cope with any future crises.

Nonetheless, dividend cuts haven’t always gone down well. Many investors faced with this situation have bid down the share price even though the decision by a company to reinvest more money could provide greater benefits down the line. Vodafone (VOD) is a good example; the dividend was cut in 2019 but the share price has subsequently followed it down. Investors may be getting nearly the same yield as before, but the shares are worth a lot less.

Increasingly people in retirement are staying invested in stocks and shares for longer. They hope the value of their portfolio continues to grow as well as generating income, and this combination of capital growth and dividends is certainly more important to pensioners than a few decades ago.

Whether a fund has the words ‘income and growth’ or just ‘income’ in their name, if you want growth and dividends, look for one with a total return mandate as this implies the manager is trying to deliver both capital gains and income. Just remember that dividend growth can be more attractive longer term than high yield as the former can represent a company going places rather than one stuck in the mud.

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