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Henderson’s Lofthouse warns of concentrated UK equity income funds

Ben Lofthouse, who runs the Henderson International Income trust, explains why structural issues in the UK stock market have made it difficult for equity income investors to diversify their portfolios.

Lauren Mason

By Lauren Mason, Senior reporter, FE Tru...
Thursday April 20, 2017

More than one-quarter of all money managed by UK equity income funds and trusts is held within just 10 of the highest-yielding blue-chip stocks, according to research from Henderson.

The firm’s research also suggests that these top 10 stocks - which are listed below - are held by an average of 70 per cent of UK equity income funds and trusts.

 

Source: Henderson

Ben Lofthouse, who runs the Henderson International Income trust, says this is unsurprising given the structural issues faced by the UK stock market and the ongoing scramble for income.

“The UK remains one of the strongest equity income paying markets in the world. It hosts a suite of multi-national corporations with long records of paying steady and rising dividends,” he said.

“More and more these strategies are being rewarded by investors, in part because of the thirst for yield amid record low bond yields and interest rates, but also because of its tendency to signal quality to investors: strong cash-flow, robust balance sheets and good corporate governance.

“If management is not spending money on important projects they are returning cash to shareholders, signalling to the market their continuing confidence in the business’ success that will in-turn bring fresh revenues for further projects. It can be true that companies awash with cash will eventually start to waste it.”

However, the manager points out that the top 20 highest-yielding FTSE 100 constituents pay 70 per cent of all UK dividends. Within this, the top 10 account for 50 per cent of UK dividends while the top five pay 35 per cent.

This is a structural flaw that has been well-documented in the past. In an article published back in July 2015, FE Trustnet warned of the concentration risk that comes along with hunting for yield amid popular UK mega-caps.

It refers to the plummeting oil price during the second half of 2014, which led to the UK oil & gas sector losing 18.67 per cent of its value over 12 months up until the time of writing.

In fact, the issue of yield concentration within the UK stock market sparked calls for the Investment Association to change the minimum yield requirement needed to retain a place in the IA UK Equity Income sector.


In another article published in August last year, star manager Francis Brooke – who heads up the five crown-rated Trojan Income fund, told FE Trustnet that dividing UK equity funds into IA UK Equity Income and IA UK All Companies sectors could be encouraging managers to take on inappropriate levels of risk to hit yield requirements, given the high dividend concentration of the UK market.

“If you’ve outperformed the market as we have for quite some time and that has been a combination of capital and income, your yield will be significantly lower than if you’d have just moved in line with the market, for argument’s sake,” he said.

The minimum sector requirement of a 110 per cent yield relative to the FTSE All Share over rolling three-year periods was reduced to 100 per cent last month.

Henderson’s research, however, shows that many investment professionals are still piling into the same dividend-paying mega-caps to generate an attractive stream of income.

Out of 52 funds and trusts in the study, the top 10-yielding UK stocks were held by the below numbers of portfolios. It shows that, on average, 70 per cent of funds hold these stocks in their portfolios.

 

Source: Henderson

“This is actually unsurprising: as equity income portfolios get larger, fund managers are forced to hold these same largest companies in order to receive enough dividends to pay all of their shareholders,” Lofthouse explained.

“It is further evidenced by the fact that, of the largest equity portfolios in the UK, the average percentage of the total portfolio held in these top ten stocks was 39 per cent. When the liquidity pool is small, fund managers simply have little choice.”


While these percentages do indeed shift over time, the manager says it highlights the issue of concentration risk. He warns that, if UK investors hold more than one UK equity income fund or trust in a bid for income, they could be holding far greater proportions of their money in a small handful of stocks than they realise.

“What happens when something goes unexpectedly and spectacularly wrong - oft referred to as a black swan event?” Lofthouse questioned.

“The Macondo oil spill in 2010 is a good example, when BP was forced to cut its dividend amid the rising and uncertain cost of the disaster. As one of the top five dividend payers in the UK this led to substantial shortfalls for equity income fund managers.”

In a bid to mitigate these risks for investors, the Henderson International Income trust has no exposure to the UK whatsoever and seeks income-yielding equities from elsewhere around the globe.

If investors had placed £10,000 into the £243m trust when it launched in 2011, they would have received £2,340.63 in income alone.

Income earned since launch

 

Source: FE Analytics

There are also a number of UK open-ended funds that don’t rely on the FTSE 100’s highest-yielders to generate attractive streams of income for their clients, as highlighted in an exclusive FE Trustnet study earlier this year. These include the likes of Ardevora UK Income, CF Miton UK Multi Cap Income and Investec UK Equity Income.


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