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Most of my ISA is built around global equities. I own developed markets, the S&P 500, smaller companies and Asia-Pacific. However, 15% of my ISA sits in something quite different: the Vanguard FTSE U.K. Equity Income Index Fund – Accumulation.

It is one of my favourite parts of my ISA portfolio. The fund tracks the FTSE UK Equity Income Index, which means it is designed to give exposure to UK-listed companies with relatively attractive dividend.

Instead of being dominated by technology companies, the fund has much greater exposure to financials, energy, mining and established consumer businesses. Companies such as HSBC, Lloyds, Shell, BP, Rio Tinto, Tesco and Unilever are far more representative of the type of businesses you find in this fund.

The difference is important to me because my global and US holdings already provide plenty of exposure to companies such as Microsoft, Nvidia, Apple, Amazon and Meta. I do not need or want every fund in my portfolio to own exactly the same type of company or rely on exactly the same source of return.

The UK represents a much smaller share of the global stock market, so I am consciously overweighting it relative to a pure global market-cap allocation.

I am comfortable doing that because I want the position to be large enough to make a meaningful difference without allowing it to dominate the portfolio. For me, 15% strikes roughly the right balance.

The fund gives me more exposure to sectors that are less prominent in the US market. Banks, energy companies, miners and mature consumer businesses often generate significant amounts of cash and return part of that cash to shareholders through dividends.

That gives the portfolio another potential source of return when growth stocks are struggling. It does not mean the fund will outperform every year. In fact, there will undoubtedly be periods when UK equity income significantly underperforms the S&P 500 or other growth-heavy markets.

That does not concern me. Diversification is not about owning a collection of investments that all behave in exactly the same way. It is about owning different assets and businesses that can contribute to returns in different economic environments.

The most attractive part of this fund for me, is the dividend income.

I own the accumulation version of the fund, which means the dividends generated by the underlying companies are not paid out to me as cash. Instead, they are automatically reinvested back into the fund.

This is where the compounding effect becomes particularly powerful.

When dividends are reinvested, they increase the amount of capital I have invested. That larger amount of capital can then generate more dividends in the future. Those additional dividends are reinvested again, which increases the capital base further.

The process repeats itself year after year.

I like to think of this as the dividend multiplier. The dividend is not simply an income payment. When it is reinvested, it becomes additional capital that has the potential to generate further returns of its own.

Imagine investing £10,000 in a portfolio producing a hypothetical 4% dividend yield, while the underlying investments also grow by around 3% per year.

If the 4% dividend is taken as cash and spent, the original investment is effectively compounding at around 3% per year. After 20 years, £10,000 growing at 3% would be worth roughly £18,100.

If the dividends are reinvested and the combined return averages around 7% per year, the same £10,000 would grow to approximately £38,700 over 20 years.

The difference is enormous.

Of course, real markets do not produce a smooth 7% return every year. The example is not a forecast. The point is simply that reinvesting income allows future returns to be earned on previous returns as well as on the original capital. This then compounds and builds wealth quicker.

UK equity income is not particularly fashionable. These companies are unlikely to generate the excitement associated with artificial intelligence or the latest technology boom, and there will inevitably be periods when they underperform faster-growing businesses.

However, that is not the job I have given this 15% of my ISA. Its role is to provide UK exposure, greater sector diversification, access to mature cash-generative businesses and, importantly, a meaningful stream of dividends that can be automatically reinvested.

What I particularly like is that this does not mean sacrificing the potential for strong capital returns. Over the past 12 months, the Vanguard FTSE U.K. Equity Income fund has actually outperformed Vanguard’s S&P 500 ETF in sterling terms. Recent data puts the UK equity income fund’s one-year return at around 28%, compared with roughly 18% for the S&P500 VUAG ETF.

One year tells us very little about what will happen next, of course. But it is a useful reminder that a portfolio of mature, dividend-paying British companies can still deliver impressive total returns.

The Compounder
Long-term investing made simple.

The Compounder is for financial education and commentary only. I am not authorised or regulated by the Financial Conduct Authority and I do not provide financial advice, investment advice, or personal recommendations. Nothing published here should be taken as a recommendation to buy, sell, hold or switch any investment, fund, pension, ISA, crypto asset or financial product. Always do your own research and consider speaking to an FCA-authorised financial adviser if you are unsure.