Buy for income and reinvest it – and the funds that help you do that

Should you buy an active fund, a tracker, or perhaps a 'smart beta' mix of the two?

Dividends matter. Depending on the decade you pick, they account for anything from 30%-90% of long-term returns from shares. Payouts are also a lot less volatile than share prices, because managements try to avoid cutting them.

Dividends can and do get cut in some years the so-called 'equity income' sector does poorly (2008 and 2009 were classic examples) because you are effectively investing in boring, value-orientated stocks, which tend to do badly when investors run for the hills, and also underperform early in the rally period, when investors flood back into low-quality stocks that survived the crunch. Yet over the very long run, focusing on and reinvesting dividends makes sense. The average fund in the UK Equity Income sector has beaten the FTSE All Share by close to 15 percentage points over three years, according to Trustnet.

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That raises two questions. Firstly, is now the right time to invest in equity income? Secondly, what fund should I use? My answer to the first is: "it depends". If you have a 20-year time period, then now is usually as good a time as any to invest. But beware that 2016 might be turbulent for dividends. Capita Asset Services' latest Dividend Monitor expects UK companies to grow dividends in 2016 by up to 3% overall, but there are huge risks to some of the biggest firms.

Dividend cover will be at its lowest since the stockmarket rally began six years ago. (Dividend cover divides earnings per share, or EPS, by payouts per share a figure of at least one is essential, and above two is desirable.) The big potential troublemaker is the commodities sector. The generous yields on FTSE 100 oil majors and miners are under threat. Given that my core view is that the commodities bear cycle has much further to run, with oil dropping through $30 a barrel and China surprising on the downside for the rest of 2015, I think we'll see much more pain for the sector in 2016.

So which equity income fund might we buy? Active managers will claim the key to success next year is to avoid resource stocks, so don't just track the FTSE 100 buy an active fund. This is probably good advice, but I'm not convinced it will shield you from the worst, and it also pretty much guarantees you'll have to accept a yield of less than 3% a year, as you avoid the riskier high-yielding stocks. Also, many equity-income specialists don't deliver over the long run instead they overcharge and underperform.

That might seem a harsh judgement. But it won't if you compare most with cheap UK equity income exchange-traded funds (ETFs) and other passive funds that use automatic, rule-driven screens to exclude certain stocks in their hunt for dividend payers.

The table below shows returns for a number of these tracker funds, including the iShares UK Dividend Plus (LSE: IUKD), State Street SPDR S&P Dividend Aristocrats ETF (NYSE: UKDV) and Vanguard's UK Equity Income tracker.As you can see, they have all beaten the FTSE 100 comfortably. (I've also highlighted some of the best-performing active UK equity income funds, which I'll return to below.)

These three trackers are forerunners of the "smart beta" revolution. Ignore the marketing jargon and the central idea is simple: why buy the FTSE 100 when you can use basic criteria to screen out the rubbish and focus on the dividend payers you want? The latest such product comes from American firm Wisdom Tree (working with UK-based partner Boost ETP).

The second table shows the key things you need to know about The Wisdom Tree UK Equity Income UCITS ETF (LSE: WUKD) compared with its peers. One big difference is that many competitors simply rank the shares in their funds by dividend yield (so roughly speaking, the higher the yield, the more shares they'll hold). They then add rules based on dividend payout history and dividend cover.

The Wisdom Tree strategy is different. As the firm notes, the fund comprises the "highest 33% of UK-domiciled companies, from the Wisdom Tree UK equity universe, ranked by dividend yield". These are used to build "a diversified basket of stocks" with no more than 3% in any one stock.

The stocks are weighted according to "the absolute amount of dividends paid". In other words, this ETF weights its holdings using the actual dividend payout in pounds, shillings and pence (also used by the SG Hinde UK Dynamic Equity ETN (LSE: HALF), mentioned here before) rather than the yield. For me the big draws are that the ETF has an attractive total expense ratio (0.29%), a less concentrated portfolio (at over 100 holdings), and that at 25%, it has a lower sector-weighting cap (to avoid outsized positions in any one sector) than its peers.

My bottom line? It's early days for this new ETF. The underlying dividend strategy makes sense and has been thoroughly tested in America. But I'm not entirely convinced that an ETF is the best bet for UK equity income. As the first tableshows, a smart active manager (with a keenly priced fund) can range far and wide, moving into mid and even small caps to generate income. They can also do far more due diligence on the underlying corporate balance sheets. Whether that'll pay off in the next few, tough, years is an unknown, but I'll be watching to see how the UK equity income battle shapes up.