Prior to Brexit and Donald Trump dominating the headlines, one of the major risks facing the UK equity income investors was the outlook for dividends from FTSE-listed companies. 
In a world where income has become a highly sought-after commodity thanks to ultra-low interest rates and bond yields, dividend cover within the UK market fallen as companies’ earnings growth has been slowing at the time when pay-out ratios have been increasing.
Dividend cover across the FTSE 350, for example, has fallen from more than 2.5 times in 2011 to less than 1 times (as of July 2016), which is the lowest level seen since the global financial crisis.
While this is clearly cause for concern as low dividend cover is usually a pre-cursor to dividend cuts, another major criticism of the UK dividend market is how concentrated it is. For example, the latest Capita UK Dividend Monitor showed that the top five largest dividend producing companies in the FTSE All Share accounted for 40 per cent of all dividends paid within the index last year.
As such, there is the belief that UK equity income portfolios are also far too concentrated as they have to rely on the same relatively small basket of stocks to produce an attractive yield.
This is obviously a risk in itself, but the major reason why fears over the UK dividend market were a such major talking point within the industry is because it is among those largest income-paying stocks where the most challenged dividends can be found.
Over the last two years, 14 FTSE 100 stocks cut their dividend but numerous experts have warned that this is a more widespread issue.
While Brexit and Trump’s presidential election victory will continue to dominate news flow, these concerns about the outlook for UK dividends should not be ignored. Indeed, our research suggests that the concerns about concentration levels across the UK market are valid.
The commonality of UK income trusts
First and foremost, it is clear that most managers of UK income trusts are generally hunting among the same pool of large-cap stocks for income and yield.
Ten most popular stocks with UK equity income trusts
Source: Kepler Partners
According to our research, 18 of the 22 direct equity trusts in the sector (or 81 per cent) hold BP, which has a challenged dividend given the recent fall in the oil price and its dividend cover of 0.43 times.
The large majority also hold Royal Dutch Shell, GlaxoSmithKline, Imperial Brands and British American Tobacco, HSBC and AstraZeneca as well though, as the table shows, the 10 most popularly held stocks by UK income trusts have varying degrees of dividend cover.
Our research also found that 23 per cent of all the assets in the sector are invested in those 10 stocks, with Royal Dutch Shell and HSBC the most popular in that respect – 3.28 per cent of the total assets in the sector are invested in each of them.
That suggests concerns about concentration levels are valid. However, we also looked into the actual average commonality of those trusts – by that we mean not only comparing the stocks they hold, but the proportion of assets they have invested in them – and, from that perspective, the picture is brighter as the average portfolio crossover across the sector is 25.8 per cent.
[Editor’s note: FE Trustnet realises that the below table is difficult to read in detail but the amount of red on the table shows the prevalence of crossover. We are trying to find a way to present this interesting chart to you in a clearer fashion.]
Crossover of UK equity income trusts
Source: Kepler Partners
To calculate that figure, we analysed each portfolio’s crossover with the other 22 members of the peer group to see which stocks those trusts have in common with each other as well as how similar their weightings to those stocks are. A crossover of 100 per cent would mean the portfolios are identical, while 0 per cent would mean they hold none of the same stocks.
Average crossover of UK equity income trusts
Source: Kepler
As such, that 25.8 per cent figure represents the average crossovers of those 22 trusts with the other members of the sector.
What this means is, while many UK income trusts do hold the same companies, the underlying weightings to those stocks do differ quite considerably across the sector. It’s also worth noting that concentration levels are lower in the IT UK Equity Income sector than in the open-ended space.
Comparison to open-ended funds
When you look at the 12 largest open-ended UK equity income funds (which combined assets under management of £52bn, accounting for 64 per cent of all assets in the sector), the commonality in holdings is greater.
According to our research, for instance, all 12 hold AstraZeneca, while the large majority hold Centrica, Imperial Brands, Royal Dutch Shell, Legal & General, GlaxoSmithKline and BP. On top of that, the actual crossover between those 12 open-ended funds is higher than in the IT UK Equity Income sector.
We used the same process to analyse the underlying similarity of those funds by looking at not only what stocks they own, but the proportion of assets they have invested in them and compared each fund to the other.
Again, a crossover of 100 per cent would mean the portfolios are identical, while 0 per cent would mean they hold none of the same stocks. High crossover is market in green while low crossover is marked in red.
Crossover of largest UK equity income funds
Source: Kepler Partners
After taking all that data into account, we found the average crossover across those 12 open-ended funds is 32.1 per cent.
While not drastically high by any stretch of the imagination, it means concentration levels across those largest open-ended funds is 24 per cent greater than in the IT UK Equity Income sector. Though much lower than across the largest members of the peer group, the average crossover across the IA UK Equity Income sector as a whole is higher than in the closed-ended sector at 27 per cent.
The advantage of investment trusts
Of course, this issue of concentration levels in the UK dividend market only becomes a major problem if some of these mega-cap stocks do indeed cut their dividend. Again, we believe trusts are better placed to deal with that potential risk.
Thanks to their structure, trusts have the ability to hold back 15 per cent of the total dividends they receive each year, helping them ‘smooth’ their dividend to shareholders by building up reserves in good years. Open-ended funds, however, have to pay-out all the dividends they receive each year to investors.
Our research shows that levels of dividend cover across the IT UK Equity Income sector are relatively high at 0.85 times. In fact, six trusts in the sector currently have dividend cover of more than 1 times, meaning that they can at least afford to maintain last year’s dividend for another year even if underlying income from the companies they own completely dries up.
UK equity income trusts with highest dividend cover
Source: Kepler Partners
It appears that boards of UK trusts have been consciously building up revenue reserves since the last shock dividend cut hit the UK market in 2010, when BP suspended its dividend payments following the Deep Water Horizon oil spill.
The Capita UK Dividend Monitor highlights that in 2009, BP had been the largest income-paying stock in the FTSE. Therefore, when it suspended its dividend, total UK dividends fell by £10bn (or 5.4 per cent).
Given its status at the time, BP was a widely held stock among both open and closed-ended UK income funds and the suspension of its dividend had a profound affect. Some 24 per cent of UK equity income trusts cut their dividend in 2010, while a further 48 per cent of open-ended UK income funds reduced their pay-out to investors.
Nevertheless, while this suggests that dividends from UK trusts are well supported over the shorter term, dividends are just one part of the income puzzle, as capital performance is also vital. Announcements of dividend cuts almost always lead to share price declines and given how many UK trusts hold the same stocks (albeit to a varying degree), the is certainly the risk that trusts’ NAVs and share prices would also take a hit if some of those mega-caps stocks do cut their dividend – as was the case in 2010 with BP.
As such, we believe now is the time for investors to analyse their own portfolios and see how at risk their UK income trust (or fund) is to an increase in potential dividend cuts. While this, of course, is no easy task – plus the fact the future is impossible to predict – there are ways in which investors can protect their overall portfolio.
These include diversifying their portfolio away from the UK market, for example. However, our research found that investors can still find UK income trusts that really do stand out from the crowd and bear little resemblance to the ‘average’ member of the sector such Finsbury Growth & Income, Chelverton Small Companies Dividend and Standard Life Equity Income.
While they carry their own risks, they are certainly avoiding those popular UK stocks with the most challenged dividends.
In a coming article, FE Trustnet will take a closer look at the three investment trusts highlighted by Paget as being potentials for those seeking to avoid concentration risk.
Alex Paget is a research analyst at Kepler Partners, whose work features in Investment Trust Intelligence. The views expressed are his own and should not be taken as investment advice.