Diversifying your equity income 
portfolio

The need for a diversified source of equity income was an urgent issue long before the coronavirus struck. 

A combination of share price gains and hefty dividends, particularly in the UK, proved useful for clients with income needs and investors seeking a more defensive source of equity exposure. 

But UK equity income funds have long remained reliant on a handful of big payers, creating dividend concentration risk, while other regions vary in terms of yield on offer and total returns. 

The average income-focused fund in the Investment Association (IA) North America sector yielded just 2.3 per cent in early January, according to FE data, compared with some 4.5 per cent from the average IA UK Equity Income fund and 4.6 per cent from the average IA Asia Pacific ex Japan fund with an explicit focus on income.

But if equity income investing seemed a daunting task even at the end of 2019, the impact of Covid-19 has entirely transformed the equation. 

The enormous market sell-off witnessed in recent weeks has seriously challenged assumptions about the defensive qualities of equity income approaches, for one. 

It has also exposed weaknesses in the UK market, which has been hit much harder than other regions due in part to added pressures from a price war in the oil industry.

While some investors smell bargains, the economic damage inflicted by the coronavirus lockdown will inevitably be deep while remaining difficult to quantify. 

“While it might not feel like it, we remain still in the very early stages of coronavirus and therefore assessing its impact on the global economy remains difficult, other than the obvious immediate shock given the closing or borders and people being confined to their homes,” explains Ryan Hughes, head of active portfolios at AJ Bell.

“It is inevitable that many companies will now suspend or reduce their dividends and this will have a direct impact on those funds that are focused on paying out income to investors.”

In this context it is hard to tell just which companies will be able to keep paying dividends, or survive altogether, in the coming year. 

This means that building a diversified source of equity income is important, but so is taking an extremely selective approach.

Recent performance

Because dividend-paying companies are supposed to take a more prudent approach than some of their peers, the equity income funds that invest in them are usually expected to lag their growth-oriented peers in rising markets but suffer less at moments of volatility.

However, on an aggregate basis the defensive characteristic of equity income has failed to materialise so far in this sell-off. 

The FTSE All Share made a stunning year-to-date loss of 33.5 per cent to 18 March, with the FTSE 100 down 31.9 per cent.

However, the average IA UK All Companies fund has struggled more, losing 34.2 per cent. 

And the fallout has been even worse for the average IA UK Equity Income fund, which is down 34.9 per cent over the same period.

A similar dynamic applies further afield over this period, if the losses have been less severe. 

The average IA Global Equity Income fund shed 21.4 per cent in sterling terms, compared with an average loss of 19.5 per cent in the growth-oriented IA Global sector. 

The MSCI World index dropped by 16.8 per cent over this period.

Taking share prices at face value, investors may now sense a bargain. 

Having looked expensive on various metrics in recent years, equities might be at a level that seems attractive for those with a reasonable time horizon and the ability to stomach the inevitable ups and downs of markets. 

UK stocks, which looked cheap relative to some of their peers before 2020, may now seem even more so.

The same thinking can apply for adventurous equity income investors, given that yields move inversely to prices.

 In theory, you can now secure the same dividend in terms of a cash amount from a company, but at a cheaper share price than before. 

Funds in the space should be able to take advantage of this.

But caution, and a serious consideration of the fundamentals, would be advised here, because many companies and sectors could see their earnings and dividends struggle in the face of the economic shutdown aimed at halting the spread of the virus. 

And while some sectors may seem like obvious winners or losers from the current situation, it is worth assessing the bottom line.

“Equity income is looking very interesting right now,” says Adrian Lowcock, of Willis Owen. “The headline yields are eye-watering, but of course they all have to be taken with a massive pinch of salt.

“The entry point to equity income looks appealing as it has been oversold compared with the rest of the market and the yields have looked attractive even before the crisis, but quality is key and dividend traps need to be avoided.”

Winners and losers

Some sectors have obviously struggled. 

The tourism and hospitality industries will take a huge hit, as will the likes of airlines. 

Similarly, equity income investors will be hit harder in certain regions because of the structure of the underlying market.

In the UK, the pronounced difficulties of equity income funds in part relate to the composition of the market and where dividends come from. 

The oil price war that broke out between Saudi Arabia and its rival producers in early March has meant that big dividend payers such as Shell and BP have seen their share price woes intensify amid the coronavirus sell-off. 

Other dividend-paying sectors have also struggled, in the domestic market and globally. 

Banks in the UK and beyond fare best in environments of high or rising interest rates, meaning the emergency cuts enacted around the world will trouble both their share prices and balance sheets.

However, share price moves and dividend yields do not tell the whole story. 

As Mr Lowcock notes, companies’ fortunes – and dividend payments – depend in part on whether they are well positioned for difficult times.

“Some sectors are going to be hit harder than others, such as the airline industry,” he says. 

“Before the crisis, British Airways owner International Consolidated Airlines Group had a decent yield, but in the light of events it is hard to see that being maintained or returning any time soon. 

“Likewise oil majors are going to be under pressure but they have historically been able to ride the rough patches out.”

As such it is useful to assess where funds – in the UK and beyond - invest by sector, and how much of a focus they have on metrics such as dividend cover and overall balance sheet strength. 

It will also be instructive to see which companies cut or reduce their dividends and why.

On the same note, investors would do well to have a balance of geographical exposures, given that companies around the world will fare differently with the coronavirus crisis.

If China recovers more quickly than Europe, for example, Asian equity income funds could receive more of a boost.

For example, pub chain Marston’s recently announced a dividend cut as it looks to weather the current storm, as did betting company William Hill, which has been hit by a slew of sport event cancellations. 

Tech name Micro Focus scrapped a payout in response to the current turmoil.

But some who alter their dividend plans may fare well in the crisis. 

WM Morrison has scrapped a planned special dividend to boost its resources for coping with the current situation, but could be in a sector that ultimately benefits from the crisis as shoppers panic buy items.

Funds

Mr Lowcock notes that companies with less sensitivity to economic activity should be the best income sources, meaning so-called “quality” shares could continue to outperform as they have in recent years.

 He favours funds such as Threadneedle UK Equity Income, a high-conviction name that has the flexibility to invest across different parts of the market.

Diversifying across different areas, using not just UK equity income funds but those operating in different regions or with a global remit, could also help. 

But given that even companies in a strong position may cut their dividend merely as a precaution, it is likely that many funds will generate less income in the next year or so.

“For [open-ended] funds, the rules state that they have to pay out all of the income they accrue each year and therefore investors should expect income to fall from these funds as companies restrict what they are paying out,” Mr Hughes adds.

As such, investors may need to lower their expectations in the shorter term – though buying quality dividend-payers at cheaper valuations could make generating income easier in the future. 

But some other routes are available.

In the open-ended space, some equity income funds sell put options on their holdings and use the fees for this activity to boost their yield. 

This practice can reduce such funds’ capital gains in rising markets, but may help to boost the income available.

Another route is via the investment trust sector, where many names have long records of increasing their dividends each year. An advantage some trusts have is the ability to pay income from their capital reserves in difficult times.

“Many trusts that focus on income have a decent income reserve and therefore may be in a position to maintain their dividend this year despite the cuts that will come from companies,” says Mr Hughes.

However, as with companies, investors should look closely at trusts to see which are well equipped to get through difficult conditions. 

Analysts at Stifel, a broker, recently warned that “newer trusts with little in reserve, those investing in specialist assets and those returning capital to shareholders by way of dividends may be especially at risk of dividend cuts”.

Investors should therefore consider diversifying across these vehicles, as well as regions, but keeping a close eye on quality and fundamental metrics such as cash reserves and balance sheet strength. 

Equity income investing will not be an easy ride in the coming months.

dave.baxter@ft.com