Those looking for an income from the stock market often turn to Equity Income funds. They provide a portfolio of dividend-producing stocks with investors standing to benefit from a rising dividend income as well as some capital growth – though like any investment their value, and the income derived from them, can fall as well as rise.
The UK Equity Income sector is home to many popular funds. Well-known managers such as Neil Woodford, Mark Barnett of Invesco Perpetual and Adrian Frost of Artemis preside over exceptionally large funds, which are often staples of investors’ portfolios. This is unsurprising as they have tended to be successful in delivering a rising income to their investors and strong overall returns.
Yet large equity income funds have a tendency to invest in many of the same underlying stocks. The FTSE All-Share index is highly concentrated in terms of income, with just 20 shares accounting for nearly two thirds of total dividends. What’s more a large proportion of dividends come from a small number of sectors: telecoms, oil & gas, financials and consumer goods. Consequently, some funds and many investors could be unwittingly relying on a relatively small number of areas, and individual companies, for their income.
Average dividend cover
Worryingly, there are question marks over the sustainability of many of the largest dividend payers. Dividend cover (the ratio of a company's net income over the dividend paid to shareholders) is at its lowest level since the height of the financial crisis. The average dividend cover across the FTSE 100 is just 1.6x for 2017, significantly below the 2.0x level generally considered to offer a decent margin of safety. This doesn’t necessarily mean cuts in dividends are inevitable, but it does indicate that an unexpected downturn in trading, or in the UK or global economy, could have a sudden and significant effect on pay outs.
More concerning still is the fact that the ten largest dividend paying stocks have an average dividend cover of just 1.1x. Yet these are often the stocks with the highest yields, and are typically the ones on which that many Equity Income rely. Royal Dutch Shell for instance (which accounts for 14 per cent of total UK dividends) yields 6.6 per cent but has dividend cover of 0.9x, which suggest the company’s dividend may not be sustainable in the long-term.
The rather odd situation is that very few UK stocks that offer a higher yield than the index itself, and it is those stocks that arguably have the most challenged dividends. Yet to meet the requirements of the Investment Association Equity Income sector funds must yield more than the market average, so some funds in this sector (in particular large ones) are effectively forced to own some of these stocks or risk being moved out of the sector.
Why investors need to be careful about choosing equity income funds
A recent report from Kepler backs this up. Some 29 per cent of fund assets are invested in ten stocks (with dividend cover of 1.04x). Investment Trusts fare only slightly better with 25 per cent of assets in the AIC UK Equity Income sector invested in ten stocks (with dividend cover of 1.17x). These statistics show why investors may need to be careful about choosing equity income funds. Many are hunting within a small band of dividend-paying stocks and diversifying with a range of funds in the same sector may not be particularly helpful.
Both active and passive funds in this area could be plagued by the risk of concentration and of key companies cutting their dividends. A significant proportion of the sector owns the likes of Shell, GlaxoSmithKline, Imperial Brands, BP and AstraZeneca. The recent issues at Pearson and Provident Financial are witness to how things can deteriorate and affect the ability of companies to fund dividends, so we would caution investors with collections of UK equity income funds to consider their portfolios carefully to avoid overlap and the risk of being too exposed to a small number of stocks.
What can investors do?
Fortunately, sensible diversification is easy to achieve by considering smaller, lesser known funds, notably those that contain a larger proportion of small and medium sized companies – or that invest in them exclusively. These may have different risks attached – notably that smaller firms are often less diversified and lack the resources of larger companies – but it may help avoid the risks involved in the lack of dividend cover and the possibility of dividend cuts among larger businesses.
Having a global approach to income generation is also important. There are a number of overseas equity income fund options that offer similar yields and help avoid being overly reliant on a handful of UK blue chip names. Again there are some different risks to consider such as currency movements affecting the investment value and level of income, but we would suggest they could be worth taking for the purposes of diversification.
For those relying on a steady stream of income it is also worth noting that investment trusts are better suited to dealing with dividend cuts. They have the ability to retain 15 per cent of their earnings in reserve whereas open ended funds have to distribute everything they receive. When dividends come under pressure, the ability to dip into reserves is an advantage in smooth out the volatility of income received. Some trusts are also currently trading at discounts to their net asset values meaning that a higher level of income is available from a similar portfolio. For instance, Perpetual Income & Growth investment trust managed by Mark Barnett potentially offers a superior yield to his popular Invesco Perpetual Income and High Income funds and trades at a discount to net asset value of 9 per cent.
This article is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in fund and other collective investments should only be made after reading the Key Investor Information Document or Key Information Document, Supplemental Information Document and/or Prospectus. If you are unsure of the suitability of your investment please seek professional advice.