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Dealing with the dangers of equity income concentration

In such an income-seeking climate, investors run the danger of increasing their individual stock risks, investing in managers with overlapping holdings. While there has been a plethora of foreign income launches offering diversification, many investors stick close to home with UK equity income funds.

The problem with UK income is that the highest dividends are quite concentrated at the top end of the FTSE.

According to Capita’s dividend monitor, for the first time since the second quarter of 2008 UK company dividends surpassed £20 billion in the third quarter. Almost 90 percent of this came from FTSE 100 companies. Just five stocks accounted for 39 per cent of all dividends over the quarter while the top 15 made up 71 per cent of payments. Such reliance on a few big payers means substantial holdings crossover is inevitable if investors hold more than one UK income portfolio.

Funds of funds mitigate crossover by seeking managers with complementary styles, those fishing from different areas of the market or even newer, more flexible portfolios.

OPM Fund Management CIO Tony Yousefian says: “It is good to hold more than one income fund, provided they are looking at different parts of the market.”

F&C Thames River co-head of multi manager Gary Potter echoes this idea, saying that investors want to hold more than one capable manager but from an asymmetrical point of view, providing insulation from varying market conditions. For instance, he says having a more alpha-generating income fund such as Standard Life’s unconstrained income alongside a more defensive manager such as Psigma’s Bill Mott or JO Hambro Capital’s Clive Beagles.

OBSR’s Richard Romer-Lee says while there may be heavy concentration among dividend payers in the UK, within the equity income sector, there are plenty of differences among managers to afford investors choice for diversification. “There are those that are more index aware, some have a greater high yield focus (such as Newton) and there are those with a blend of value and growth and managers with a total return focus (such as Invesco Perpetual’s Neil Woodford).”

One obvious variance between funds is their stance on market cap. Yousefian said he looks at manager selection last, scoping out where he wants to be positioned first, such as large or small caps, and then looking at manager commonality. While up until the middle of this year, smaller companies have fared better than large caps, it has since reversed. So although OPM may be leaning towards managers with higher large-cap positions, Yousefian says he still wants to have exposure to the entire market. OPM holds Gervais William’s new income fund which while multi-cap does have a bias towards the mid and smaller end of the market.

Looking a little deeper at portfolios can also yield some obvious differences, enabling better combinations. For instance, according to analysis from Style Research, George Luckraft’s Axa Framlington monthly income is a world away from Woodford’s income funds. The two managers appear to be taking opposing sector bets, with Woodford favouring pharmas and healthcare and Luckraft liking industrials and financials. Luckraft is value focused and has a heavier small cap exposure, investing in the Aim market, while Woodford is more balanced between value and growth and is tilted towards large caps. In fact, Style Research shows that as of September, the two managers had just eight stocks in common with Luckraft, through his small-cap positions, featuring more “unique” holdings than his peers at 47 per cent of his fund.

Like Woodford, Artemis’ Adrian Frost is also considered to be unconstrained with regards to benchmark but at the moment his portfolio is more value-oriented than Woodford’s, Style Research shows.

As of September, Frost was closer to market weightings across sectors than Woodford although like the Invesco Perpetual manager, overweight healthcare.

Frost’s biggest bets at the moment appear to from overseas exposure, ranking among the highest tilts he has had in that area over the past eight years. Across the peer group, Style Research also shows Frost has one of the highest exposures to pure dividend-paying companies (top 20 per cent of the peer group).

One of the greatest challenges in diversifying selection from this sector is investors’ traditional reliance on a few well-known managers. Evidence of this is the fact that there are 10 funds of more than £1bn in size in this sector, FE data shows. However, both Yousefian and Potter point out there is scope for diversification by investing in newer or smaller funds.

Potter says funds such as Liontrust income, now managed by Gary West and James Inglis-Jones, and its former manager Jeremy Lang’s new portfolio Ardevora income, offer differences. Yousefian says Trojan income, managed by Francis Brooke, is anther solid option. While the fund may be managed in a similar in style to Woodford, its smaller size (at £382m versus the £7bn-plus size of Woodford’s funds) means it is more of “a tugboat than an oil tanker,” giving it greater maneuverability.

Instinct for many investors is to seek out or buy those managers outperforming at the moment. However, two managers at the top today may both be at the bottom tomorrow if their style goes out of favour. Over the three years to October 31, the top-performing equity income funds are Unicorn UK income and Chelverton UK equity income, both featuring smaller company biases. With the trend towards smaller companies waning over six months to November 25, both have moved down into the bottom half of the peer group.

This is why combining opposing styles is so important. Yes, having multiple UK equity income funds may mean investors are heavily exposed to a single stock, such as BP, and if something happens to that one company it could put a hole in returns. However, there remain plenty of other ways in this sector to diversify.

As with any fund peer group, there are managers that work better together and those investors should avoid holding in unison. Identifying which to combine is the hard – and essential – part.

Kira Nickerson is a freelance journalist


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