Clifford, (pictured) who manages the Lazard UK Income fund, believes equity income managers’ heavy reliance on large caps is dangerous – especially as most investors choose equity income funds that are very similar to one another. He says that although it is understandable that investors flock to blue chip pharmaceuticals and consumer goods stocks, they have a better chance of success if they are diversified across the entire market cap spectrum, because even the highest-quality multinationals cannot guarantee a sustainable dividend.
"Aside from the obvious dividend yield, income stocks tend to be perceived as large, mature companies which generate lots of cash and can return it to shareholders," he explained. "Income stocks tend to be found in defensive, rather than cyclical, sectors."
"All these characteristics mean that income strategies have historically been protected from volatile market movements, but lag a rising market, and can also be highly concentrated in a few sectors, such as pharmaceuticals and utilities."
"However, these mega cap stocks are not without risks, especially when relying on their dividends for income. Memorable examples include BP’s dividend suspension after the Gulf of Mexico oil spill in 2010 and more recently the cuts announced by Aviva and RSA."
While most investors associate small and mid caps with higher levels of risk and volatility, Clifford says that from an income perspective, large caps have often turned out to be anything but safe havens in the past.
This, combined with the diversification benefits available further down the market cap scale, makes a compelling case for small and mid caps in the manager's view.
"Over the past 10 years about a third of the current FTSE 100 constituents have cut or suspended their dividend payments, including perceived safe havens such as utilities and telecoms," he said.
"Further down the market cap spectrum, however, the opportunity set increases significantly; of the 602 companies in the FTSE All-Share, 196 have a dividend yield greater than that of the market, and almost half of these have a market capitalisation of less than £500m."
"This also provides the opportunity for exposure to sectors such as technology, where there are limited yield opportunities among large cap companies."
"Many of these companies also offer superior earnings growth, which we believe is the best way to ensure sustainable dividend growth."
"Over the past 10 years, small and mid cap companies have delivered annualised growth trailing dividends of 9.8 per cent and 9.1 per cent respectively, far greater than their FTSE 100 counterparts at 5.5 per cent per annum," he added.
Unlike other equity income managers who make the case for a multi-cap approach to investing, such as FE Alpha Managers John McClure and Giles Hargreave, Clifford’s fund has no particular bias to small or mid cap stocks.
He has managed the £87.4m Lazard UK Income fund since September 2008.
According to FE Analytics, the fund has returned 51.38 per cent over that time, compared with 49.54 per cent and 46.51 per cent from the IMA UK Equity Income sector and the FTSE All Share, respectively.
Performance of fund vs sector and index since Sep 2008
Source: FE Analytics
The Lazard UK Income fund has also beaten the sector and the index over one and three years, albeit with more volatility. It is yielding 3.9 per cent.
Our data shows that Lazard UK Income is underweight the FTSE 100. Some of Clifford’s largest underweights include drinks companies Diageo and SAB Miller, along with Imperial Tobacco.
Nevertheless, he still holds 67 per cent of the fund in the UK’s leading blue chip index with the likes of GlaxoSmithKline, Vodafone and HSBC all major holdings. The rest of the fund is split between the FTSE 250, Small Cap and AIM indices.
Although Clifford says investors should not be over-reliant on the UK’s largest companies, he says there is definitely a case for holding them as part of a diversified multi-cap strategy.
"While mid and small cap stocks can be an attractive component of an income strategy, larger companies still have an important role to play," he said.
"The majority of the overall UK market yield comes from larger companies: around 75 per cent of the yield contribution comes from mega caps with a market cap in excess of £10bn."
"These stocks are also highly liquid and although not immune to negative surprises, their dividend streams provide a relatively predictable core for an income portfolio.
"In extreme market conditions, such as 2008, larger companies also tend to defend better than their smaller counterparts."
"Using an all-cap approach to investing opens up a wider opportunity set for investors and enables a greater diversity of income sources. However, investing in small and mid cap stocks requires specialist skills and reduced liquidity in particular means portfolio construction is paramount."
"However, we believe that over time, the increased opportunity for growth in income is worth the effort," Clifford added.
Lazard UK Income has an ongoing charges figure (OCF) of 1.34 per cent and requires a minimum investment of £2,000.