Neptune Investment Management CEO Robin Geffen says managers in the UK equity income space are running “unacceptably high risks” by relying on too few stocks to deliver yields. 
Geffen – who also manages the firm’s £205.9m Neptune Income fund – says many equity income funds depend on just a handful of names for their dividends.
He said: “We believe that dividend risk is greater than ever. UK dividend cover is lower than it was during the financial crisis.
Less than 30 per cent of UK companies yield more than the FTSE All Share. If you look at holdings within income funds, there are some startling figures.”
Claims about the UK equity income sector made by Geffen include:
- 63 per cent of income funds rely on one company to deliver 8 per cent of their yield
- 24 per cent income funds rely on one company to deliver 10 per cent of the yield
- 39 per cent of income funds rely on BP and Shell to deliver more than 10 per cent of yield
- 33 per cent of income funds rely on the top 10 holdings to deliver more than half the yield
“These are staggering numbers that show how many income funds rely on very, very few stocks to deliver yield,” he said.
The most held stocks in funds’ top 10s in the UT UK Equity Income sector are Imperial Brands and BP, which are present in 28.13 per cent of portfolios.
Pharmaceuticals company GlaxoSmithKline was found in 22.92 per cent of top holdings, while British American Tobacco, HSBC, Rio Tinto and Royal Dutch Shell were held in the top 10s of more than 15 per cent of funds in the sector.
Stocks most held in the top 10 for UT UK Equity Income sector
Source: FE Analytics
“Is your equity income manager doing enough to protecting you from dividend risk? I urge you to go back, look at income holdings and find how exposed you are to individual stocks,” Geffen added.
“We don’t have to go very far back in to the financial crises when the banks slashed dividends. We don’t have to go far back to when miners slashed dividends and BP slashed its dividend.”
“To me, there are funds running unacceptably high risk to produce a yield on the fund.”
Another issue for equity income investors is too much exposure to the small- and mid-cap sectors, according to Geffen.
He said: “We have a record amount of funds in the income space invested in small- and mid-cap stocks, well over 40 per cent of all funds by value.”
“Though historically they may have been a good way to try and get returns, a lot of people haven’t realised that it’s been an asset allocation decision that’s been successful rather than stock picking.”
Highlighting this Geffen says of the industry’s 121 small- and mid-cap funds, some 113 from have outperformed the FTSE 100 since 2009.
Performance of IA UK Smaller Companies sector vs FTSE 100
Source: FE Analytics
“What we had then was low interest rates, low inflation, strong sterling, high consumer and business confidence,” he said.
“What have we got now? Higher rates in the US, higher inflation, weak sterling and political, social and economic uncertainty best exemplified by the issues of Brexit. The economic conditions have very much changed.”
He added: “We looked back at over the last six years of income fund performance. In 2016 note that 10 per cent UK equity income managers outperformed the FTSE All Share. Most didn’t even come close.
“If you back to 2015, 2014, 2013, over 80 per cent of income manager outperformed the FTSE All Share by investing in small- and mid-caps.”
However, the manager said the “free lunch” in small- and mid-cap stocks was over and was a key reason for underperformance of UK equity income managers in 2016 and why many had failed to grow dividends.
He added: “You should be very aware of the fact that liquidity in small- and mid-caps has shrunk considerably over the last 12 months.
“It started with Brexit and continued with a vengeance after. After Trump’s victory it was large-caps that outperformed.”
Geffen also highlighted the relative expense of ‘bond proxies’ in the current market environment.
“If we look at bond proxies and how they performed, yes they did well from 2011 to 2015, but in 2016 they rolled over we believe they will carry on rolling over,” he said.
“Quality growth is now trading at a 45 per cent premium to wider market. Think stock selection is absolutely crucial in the current environment.”
Geffen says the Neptune Income fund remains diversified across 33 equally-weighted stocks, where no single holding accounts for more than 3.6 per cent of the total fund yield.
“The top 10 holdings of the Neptune Income fund account for 20.6 per cent of the yield, against 45 per cent for the average,” he said.
“There are funds out there which you may not be aware of that rely on one company to deliver up to 15 per cent of the yield of the entire fund. There are funds out there where 80 per cent of the yield comes from 10 stocks.”
The manager says the fund – which invests predominantly in large- and mega-caps – is balanced and very carefully designed to perform under all market conditions.
Over three years, the fund has returned 28.36 per cent, compared with a gain of 19.94 per cent for the benchmark FTSE All Share index and a 19.22 per cent for the average IA UK Equity Income fund.
Performance of fund vs sector & benchmark over 3yrs
Source: FE Analytics
It yielded 5.01 per cent, well above the 3.8 per cent required yield for inclusion in the IA UK Equity Income sector.
“We actually grew our dividend in 2016 by 13.3 per cent, we estimated that we would grow it during the year by 6-7 percent,” Geffen said.
“We very carefully made a conservative estimate, but the circumstance of last year, a difficult year for people to predict what was going on with Brexit and surprise result in the American presidential election.”
The fund has an ongoing charge figure of 0.83 per cent.
In a future article, FE Trustnet will look at the funds that rely heavily on one stock or just a handful for yield.