Among those on the list are Nick Kirrage and Kevin Murphy’s £1.5bn Schroder Income fund, as well as BlackRock UK Income and Standard Life UK Equity Higher Income.
Source: FE Analytics
Schroder Income, for example, has 8.02 per cent in AstraZeneca, according to its latest factsheet in September, which is currently yielding 5.31 per cent.
The fund is yielding 3.71 per cent, which means just under 10 per cent of its dividend comes from the pharma stock.
It must be stressed these figures are estimates – the study doesn’t take into account when the managers bought the stocks and a fund’s yield tends to be historic, reflecting when the last dividend was paid.
However, FE Research’s Rob Gleeson points out that if the stock was bought at a lower share price than it is today, the dividend risk is actually greater.
An overreliance on a single company led to a surge of dividend cuts across the popular IMA UK Equity Income sector in 2010 and 2011, following the BP Macondo disaster. Newton Higher Income was among those worse affected.
BP remains a favourite with managers today, in no small part thanks to its 6.36 per cent yield.
Some managers hold up to 9 per cent in the company, which continues to be plagued by fines as a result of the oil spill.
Royal Dutch Shell, currently yielding 5.13 per cent, is also relied upon heavily by managers, but again there are many concerns about the stability of its dividend – not least because of its poor cash generation.
Standard Life’s Thomas Moore is among those who believe both Shell and BP could be at risk of cutting their dividends in the coming months.
Tim Cockerill, investment director at Rowan Dartington, thinks dividend risk is a big problem, particularly in the UK where a small number of companies dominate the dividend market.
He points out that funds have cut down dividend risk within their portfolios, given that BP and Shell account for approximately 25 per cent of all dividends paid out in the UK.
However, he says relying on a single company to generate 10 per cent of yield could be an issue if manager gets their stockpicking wrong.
The sector’s controversial 110 per cent yield target may have forced some managers to increase their weighting to a single company, Cockerill says, with BP and Shell often a fund’s biggest holding by some distance.
R&M UK Equity Income has a 7.5 per cent weighting in Shell, with the second biggest position – HSBC – accounting for 5.1 per cent of assets, for example. BlackRock UK Income has 8.2 per cent in Shell, while British American Tobacco has a 6.6 per cent weighting.
“I think the yield target could be a factor in some cases, because equity income has been very popular and yields have come right down,” Cockerill said.
“Clearly, if a manager is under pressure to hit the yield and tops up their weighting to help the cause, those managers are going to struggle badly.”
Ben Williams (pictured), an investment manager at Saunderson House, tends to avoid UK equity income funds with big weightings to a handful of large cap high yielders and smaller weightings to low yielding companies.
“In general we look for funds with more of a spread of companies, each contributing to the overall yield with well covered and growing dividends,” he said.
FE Trustnet will identify some of those that fit this criteria in an upcoming article.
Cockerill points out there are always risks when investing in an active manager, and even the very best can make mistakes – especially if something completely unforeseen like the BP oil spill occurs.
“If a manager is concerned about dividend risk you’d expect them to take some action,” he said.
“Sometimes you’ve got to take some risks to get the rewards.”
A spokesperson for Jupiter acknowledged that dividend risk in Ben Whitmore’s £2bn Jupiter Income fund is high, pointing out that the manager is looking at ways to reduce reliance on single companies.
“Ben is first and foremost a high conviction stockpicker who chooses to manage a concentrated portfolio of around 45 stocks. He has recently been looking to reduce the concentration of the companies providing the [fund’s] income, with a view to making the fund less vulnerable to the performance of one individual company such as BP,” said the spokesperson.
Whitmore (pictured) only took over from Anthony Nutt in 2013.
Jupiter Income is currently yielding 4.5 per cent and therefore well within the 110 per cent yield target of the FTSE All Share.Kevin Murphy, co-manager of the Schroder Income fund, accepts it could come under pressure if AstraZeneca is forced to cut its dividend; however, he points out that it’s his job to take risks, in order to outperform over the long term.
The manager says he always targets companies with sound balance sheets and good dividend cover, which significantly lowers the risk of cuts.
“As equity investors, we do take risks but only where we believe we are compensated for that risk,” he said.
“When it comes to constructing our income portfolios we consider dividend risk as one aspect of the process of the stock selection. We would never have a large position in the fund if we thought the company’s balance sheet wasn’t excellent, free cash flow prodigious and dividend sound.”
“That doesn’t mean that a Macondo-type event – a financial hit of 30 per cent of the company’s prevailing market cap – can’t happen. If an event like this was to hit a number of other high yielding companies in the market, they would probably be insolvent and the dividend would be passed. In that scenario, it is not simply the fund’s dividend that is at risk, but the client’s capital too.”
Murphy (pictured) adds that he and co-manager Nick Kirrage utilise their ability to invest up to 20 per cent of the portfolio in non-UK equities, providing investors in Schroder Income with more diversification.
“For example in the pharmaceuticals space we have invested in Eli Lilly, Merck and Pfizer in addition to [AstraZeneca and GlaxoSmithKline.] We have around 20 per cent of our portfolio in pharmaceuticals, but diversified across five companies rather than just the two UK companies,” he said.A spokesperson for Standard Life said the High Income team has every confidence in HSBC not only maintaining its dividend, but growing it.
“Dividend risk is always a consideration when constructing a portfolio and our focus on change stock selection methodology will generally help us avoid companies which cut their dividends,” they said, “Although HSBC is a large position in the fund we feel comfortable with their balance sheet and therefore barring unforeseen events, their ability to continue to grow the dividend.”
“HSBC has grown its dividend by around 10 per cent each year in recent years, underlining management’s confidence in their underlying earnings progression.”
Interestingly Newton Higher Income, which was badly affected by BP’s dividend cut in 2011, was initially flagged up as one that relied heavily on Shell, but manager Chris Metcalfe has since confirmed that he has decreased his weighting from 7.61 per cent in August to 5 per cent at time of writing.
Another manager who has recently made his fund less reliant on a handful blue chip companies is FE Alpha Manager Mark Barnett.
He explained earlier this year that he wasn’t comfortable holding more than 6 per cent of his Invesco Perpetual Income and High Income funds in any single company, explaining why he sold down his holdings in Astra and Glaxo.
The two funds have had to move to the IMA UK All Companies sector, with Barnett insisting he is not prepared to adhere to the 110 per cent yield target if it means comprising his portfolio.
Adam Avigdori, co-manager of the BlackRock UK Income fund, points out that the fund’s income stream on a sector basis is very diversified, which helped it weather the BP dividend cut.
“The BlackRock UK Income yield is fairly diverse by sector – the largest contributor is the staples sector, accounting for 16 per cent of the yield,” he said.
“The fund had a holding in BP at the time of both the prospective and respective dividend cut but managed to grow the income in 2010 despite this. This was because the fund had a diversified income base and was able to make up the shortfall elsewhere and grow the dividend 2 per cent year on year.”
Some of the funds in question are constrained in their approach. The JPM UK Higher Income fund, for example, typically only takes a 1 per cent overweight position in a company.
“The high absolute weight in Royal Dutch Shell can be explained by the fact that the stock makes up 7.1 per cent of the benchmark, and hence our active position in the stock is materially less than 1 per cent,” said manager Thomas Buckingham.
“As we view Royal Dutch Shell as an attractive income stock, it would not make sense for us to hold a smaller weighting, as this would result in an underweight position versus the benchmark, and hence underperformance for the fund were the stock to outperform.”
The £684m Scottish Widows UK Equity Income portfolio is one of three SWIP funds now managed by Aberdeen, following its acquisition of the firm earlier this year.
All are enhanced passive strategies.
Boyan Filev, co-head of quantitative investments at Aberdeen, said: “We do consider dividend risk when managing these UK income portfolios and we aim to diversify this risk for the reasons you have highlighted.”
“According to our calculations 50 per cent of [SWIP UK Income] contributed 60 per cent of the overall fund yield.”
“When measuring dividend risk we also consider our active position relative to our benchmark. In the specific case of Shell, while we have high absolute holdings in this name, our active position relative to FTSE All share is very small at 0.2 to 0.3 per cent. Therefore if an event similar to BP occurred for Royal Dutch Shell, our relative yield would be hardly affected.”Whitechurch’s Gavin Haynes (pictured) says a good way to cut down on dividend risk is to hold funds with different styles and objectives, ensuring that the top-10 companies aren’t always the same.
“We look to diversify the equity income stream for investors in our portfolios.
As well as core equity income funds we will use funds that have a focus on UK smaller companies and overseas equity income funds, to reduce the risk of unexpected dividend cuts from UK blue chips stocks,” he said.
R&M, UBS and Halifax were unavailable for comment.
