Geographic diversity and a mix of investment styles are key in generating income and capital growth.
In a world with interest rates and bond yields near record lows, UK equities remain popular among UK investors in the hunt for income. Investors now hold £63.1bn in open-ended UK equity income funds – nearly four times the amount they hold in open-ended global equity income funds.1 This is mirrored in the popularity of closed ended funds; UK investors currently hold £11.8bn2 in UK equity income investment companies - many of which are trading at a premium - compared with £3.4bn3 in global equity investment companies.
However, yields on UK equities have fallen, dividend cover has reduced, and pay-outs remain dependent on the fortunes of a narrow concentration of companies. Is it time for investors to look further afield for equity income?
Concentrating on the income challenges
The UK equity income market is highly concentrated. Income investors are disproportionately dependent on the UK’s largest multinational companies. In 2016, five companies accounted for 38% of all dividends paid out; Royal Dutch Shell alone accounted for £1 in every £8 paid out4. Globally, there is less concentration; the top ten global dividend payers, for instance, only accounted for 9.5% of global dividends last year.5
This dependence on a small group of large companies for dividends is reflected among UK equity income funds. According to data from Morningstar, one in five UK equity income funds analysed relied on their top ten holdings for more than 50% of their yield.6 This concentration poses a risk for investors, should one or several of these dividend stalwarts run into difficulty.
Use of multiple UK-focused funds can exaggerate the risk. Investors often hold several funds to protect against the impact of a single fund manager’s performance, meaning stock-picks and investment strategies are frequently duplicated.
Capital erosion also poses a problem for investors drawing an income rather than reinvesting it. Equity income funds are not always designed for growth, prioritising high yields. Yet inflation has been rising7, meaning that portfolios need to grow even more rapidly lest holdings fall in real-terms value. For retirees, for instance, who are likely to be drawing down a certain amount from their pot each year, the issue of capital erosion is even more acute.
Bringing diversity: An alliance of best ideas
For investors looking for global diversification, access to capital growth as well as a respectable dividend, Alliance Trust’s alliance of best ideas can form a core part of a long-term income solution.
The alliance of best ideas provides investors with access to eight complementary best-in-class8, high conviction global equity managers. With around 200 stocks in the Trust’s portfolio, investors have access to true global diversity, and a broad mix of investment styles, at a competitive cost.
Unlike with many equity income funds, investors in the Trust should be well placed to benefit from capital growth. This may present an opportunity for income investors in drawdown to ensure their invested funds do not diminish too quickly. However, as the equity portfolio is designed to outperform the MSCI All Country World Index by 2% per year after costs over rolling three year periods, its return could also be used to generate income through selling down shares.
The Trust’s approach is designed to produce income as well as capital growth. The Trust currently delivers a net yield of 1.9%9, and has increased its dividend every year for the past 50 years, supported by the dividends of the underlying companies. Like all investment trusts, Alliance Trust also has the capability to pay dividends out of revenue reserves, which could enable it to maintain dividends even in times of lower income generation. This is a key benefit of investing in an investment trust, rather than an open ended fund. The frequency of the dividend, every quarter, provides a regular income for investors, whether supporting spending in retirement, or funding regular financial commitments such as school fees.
Diversification is one of the most pivotal risk management exercises an investor can take, whether they are looking for growth or income. Given the concentration risk involved in the UK equity income market, it’s important investors take a global perspective, and consider a broader range of strategies to secure the diversity they need.
1 Investment Association: Figures correct as of September 2017: https://www.theinvestmentassociation.org/fund-statistics/statistics-by-sector.html?what=table&show=21
2 Alliance Trust analysis of AIC UK equity income sector data sourced by Morningstar, correct as at 20 November 2017.
3 Alliance Trust analysis of AIC Global equity income sector data sourced by Morningstar, correct as at 20 November 2017.
4 Capita Asset Services Dividend Monitor, January 2017
5 Janus Henderson Global Dividend Index, January 2017
ONS data indicates that since October 2015CPIH has steadily been increasing from a low of 0.2% - 2.8% Oct2017
8 As rated by Willis Towers Watson
9 As of 30 September 2017: https://www.alliancetrust.co.uk/globalassets/documents/factsheets-2017/at-plc-factsheet-september-2017.pdf