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UK Equity Income

12 June 2017

Over the last 12 months or so there has been a great many column inches devoted to UK equity income. For instance, the Investment Association has been consulting for probably 12 months now with fund management groups that have representation within the sector to find a way around what is a major problem. Richard Philbin chief investment officer at Wellian Investment Solutions explores the issues.

Due to Quantitative Easing, central banks globally have cut interest rates and forced investors up the “risk spectrum” in search of income. This should be nothing new to anybody who pays even the slightest interest in financial markets. Historically, you could earn income from having money in bank deposits. Even government debt provided a nice income stream and yield too. To boost that yield there were the options of corporate debt, high yield, equity income, property and so on. With interest rates remaining incredibly low, the chance of living off income on deposit becomes incredibly hard. The same can be said for government debt. Many banks in Europe actually charge for having money on deposit! Many government debt issues still offer negative yields. We last commented on how difficult it is to find income in this changing world, and it will take many years and many more column inches once this Quantitative Easing “experiment” has played out for capital markets to return to normality. I have lost count of the times I have read about “the new normal”, whatever that is, or turns out to be in relation to capital markets. Even though markets change, client requirements for a diversified and balanced portfolio to meet with their income and growth objectives tend not to and this is a very tough challenge at the moment for those who build portfolios and manage client accounts.

Taking just one part of the asset allocation conundrum – equity income – and taking just one part of that – the UK (as represented by the FTSE 100) it becomes very obvious when looking at the table below that creating a balance is not easy at all.

If you invested in a FTSE100 tracker and took the income, it wouldn’t be a wild accusation to assume that the dividend received would come from a good number of those companies. Unfortunately, the table below shows a very different output. Royal Dutch Shell and HSBC account for over 25% of the total income received from the 100 largest companies in the UK. If you then add BP – the third largest contributor – into the melting pot, almost 1/3 of your total dividend income comes from just three companies. What’s even more scary is that 2 of the three both do EXACTLY the same thing. In essence, those who invest in the FTSE 100 and take dividends are depending very heavily on the success of the profitability of the oil industry which then begs a (very important) further question:

·        What if Royal Dutch Shell and BP cut their dividends?

 


Looking a little deeper, you will find more than one similar story. Lloyds Bank and HSBC operate in the same industry (banks) as do Imperial Brands and British American Tobacco (tobacco). You will also find GlaxoSmithKline and AstraZeneca in the same sector (pharmaceuticals) and all of those names are in the table above.

The UK stock market has always been one of the highest yielding equity markets as well in the developed world and yet these ten names account for over 40% of the total income received from investing in the largest 100 companies by market capitalisation in the UK. Is this number a little too concentrated? Should the equity income achieved from a portfolio be more diversified?

Even though it seems like you are getting a diversified investment by investing in the FTSE 100 (because – ultimately your portfolio contains 100 stocks) there are other risks that need to be considered – sector concentration and income concentration are only two.

Factors like those above need to be considered very carefully when building portfolios for clients that produce income. We do not want to be too reliant on a few stocks or sectors as this drives up correlation risks – why would a fall in the oil price for instance affect Royal Dutch Shell’s profitability (and therefore dividend) substantially more, or less, than BP’s? To diversify income streams from the equity space, there are still a number of options available to fund selectors such as exposing a client to international stocks, or to companies with a smaller market capitalisation for instance. But by doing this, risks change. Currency movements, increased share price volatility, tax rates, and many other factors will need to be taken into account when creating a balanced income stream. Different correlations will emerge which will, by default, change the shape and the risks of the portfolio. Just another day in the life of a portfolio manager trying to build a diversified portfolio for their clients….

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