More than half of the dividends paid in the UK last year came from just 10 stocks, such as Shell, HSBC and Vodafone, according to data from Bloomberg supplied by Montanaro.Because of that, the majority of large cap UK Equity Income managers hold many or most of those 10 stocks in their portfolios.
However, Charles Stanley Direct’s Rob Morgan warns investors not to put all their eggs in one basket.
“There is a lot of overlap in the big UK Equity Income funds and you could find that if you hold a number of those then you have a lot of exposure to the likes of BP and GlaxoSmithKline,” he said.
“I think it is a good idea to look to diversify into some income funds which have a bit more flexibility.”
With that in mind, FE Trustnet looks at possible alternative routes to diversifying your income stream, be it by going down the market cap scale, going global, or looking to specialist funds.
Mid and small cap UK
The first option is to continue keeping your money close to home, but with a focus further down the market cap scale.
“A good way to diversify your income is to invest into funds which buy medium and smaller sized companies,” Morgan said.
“They tend to outperform large caps over the long-term and if the domestic economy continues to pick up, then these are the sorts of companies that will benefit.”
Funds with a decent exposure to small and mid caps have topped the IMA UK Equity Income sector over recent years.
The real champion of the strategy has been FE Alpha Manager John McClure’s five crown-rated Unicorn UK Income fund, which has virtually no exposure to the FTSE 100.
It is the best-performing fund in the sector since its launch in May 2005 and it also has some of the highest returns over one, three and five years.
Performance of fund vs sector and index since May 2004
Source: FE Analytics
PFS Chelverton UK Equity Income, Marlborough Multi Cap Income and CF Miton UK Multi Cap Income – all of which have high exposure to mid caps – have also been among the top performing funds over recent years.
However, Morgan points out that while those sorts of funds should outperform over the long-term, they have also had a very good run of late.
“You will get more volatility from those sorts of funds and they have performed very well recently, so it could be argued that the best time to buy them was a couple of years ago,” Morgan said.
Also, while small and mid cap UK equity funds will hold different companies from the likes of Artemis Income and Invesco Perpetual High Income, they will still be exposed to headwinds facing the UK market.
Global
With investors wanting to move their money out of the UK’s concentrated dividend market, global equity income funds have become increasingly popular in recent years.
Managers within the sector have a huge degree of flexibility as they can invest in companies across global equity markets.
One of the criticisms of the sector is that investors could still be getting overlap exposure with some of the UK’s biggest stocks, but Morgan is a fan of global equity income funds for investors who want to diversify their income stream.
“Global equity income funds tend to be quite diversified. They actually have more of a bias to the US and Europe and though you may get some overlap in the UK, it generally isn’t too bad,” he said.
Some of the leaders in the global equity income space include M&G Global Dividend, Newton Global Higher Income and Veritas Global Equity Income.
Morgan also rates the Aberdeen World Equity Income fund, which he describes as a “staple heavyweight that you can hold for the very long term”.
The fund has slightly underperformed since its launch in 2009, which can be attributed to its poor returns over the past 18 months or so.
It has just 18 per cent in the UK, with the rest of the portfolio spread across the US, Europe, Japan, Asia, Australasia and Latin America.
Other developed markets
Instead of taking an all-encompassing global approach, investors could also use other regional or country-specific developed market equity income funds.
For example, while the eurozone crisis is by no means over and deflation in the European economy is a genuine concern, companies within the region are well-known for rewarding their investors with dividends.
“Europe remains comfortably the second most important region in the world for income,” according to the Henderson Global Dividend Index report.
Some of the income plays in the IMA Europe ex UK sector include the likes of BlackRock Continental European Income, Cazenove European Income and Invesco Perpetual European Equity Income – all of which have beaten the sector over recent years.
Performance of funds vs sector over 1yr
Source: FE Analytics
Investors could also turn to the likes of Japan and the US via funds such as Jupiter Japan Income or Threadneedle US Equity Income.
A number of experts have voiced their optimism over the two regions: for example, FE Alpha Manager James Thomson believes the US will continue to lead the global recovery and Seven Investment Management’s Chris Darbyshire recently told FE Trustnet that now is the perfect time to buy Japanese equities as “Abenomics” is starting to feed through to the economy.
One issue, however, with buying these funds is that they don’t offer much in the way of a high starting yield.
For example, Neptune US Income has the highest yield in its sector at 3.14 per cent and CF Morant Wright Nippon Yield is the highest in its sector, with a payout of just 2.38 per cent.
Global emerging markets
A number of emerging market and Asian income funds have also been launched over the last few years.
However, emerging markets have struggled recently as investors have become concerned about China’s economic slowdown, the impact of the Fed’s QE tapering and geo-political risks such as the current Ukraine crisis.
All told, leading emerging market indices have considerably underperformed against the likes of the FTSE All Share and the S&P 500 over the last three years.
Performance of indices over 3yrs
Source: FE Analytics
Chris Spear, managing director at Spear Financial, says that while the macroeconomic outlook is the major headwind facing investors who want exposure to emerging markets, the current low valuations tied in with the still good long-term growth outlook mean that now is a good time to begin dipping into the sector.
“I would say that investors can get their timing wrong. Emerging markets, and by extension commodities, have performed poorly recently but now everyone is steering clear of them. However, at some point the market will turn,” Spear said.
Spear also points out that if investors were to take an income approach to emerging market equities, then while the value of their units could fall over the shorter term, they should still receive dividends that they can either collect or re-invest at a lower price.
The standout group for emerging market income has, in the past, been Newton.
Its five crown-rated Asian Income fund, which is headed up by the experienced Jason Pidcock, has been one of the best performing portfolios in the IMA Asia Pacific ex Japan sector over three and five years.
The £3.9bn fund has a high starting yield of 4.9 per cent, though it has underperformed recently due to various stock-specific issues.
Outside of Newton, the likes of Somerset Emerging Markets Dividend Growth, Charlemagne Magna Emerging Market Dividend, Liontrust Asia Income, Polar Capital Emerging Markets Income, Standard Life Global Emerging Markets Equity Income and UBS Emerging Markets Equity Income have all performed well over recent years.
Specialist closed-ended funds
Investors can also turn to a number of high yielding specialist investment trust sectors to diversify away from the UK’s largest companies.
For example, there are trusts that will only invest directly in either property, infrastructure or renewable energy.
Experts tend to agree that these sorts of trusts pay a safe and inflation-hedged dividend due to the nature of the asset classes they invest in.
The average direct UK property trust, for example, has a yield of 6.8 per cent.
Premier’s Simon Evan-Cook recently told FE Trustnet he was buying into the sector in expectation of a growth in rental yield this year.
The problem with these sorts of trusts, however, is that they are now very expensive, with the average closed-ended property fund trading on a hefty 11.8 per cent premium to NAV.
Cantor Fitzgerald’s Charles Tan recently told FE Trustnet that investors should realise they are taking a big risk when they buy this sort of trust on such a wide premium.
“If you take the fact that interest rates won’t rise until 2017, as the Bank of England says, if you are going to see savers having their savings eroded away by negative real interest rates, there’s a case for holding these for a little bit longer,” he said.
"But the point to make here is that once people even get an inkling interest rates are due to rise, as soon as expectations turn, those funds could fall out of favour very quickly."
