Dividend concentration has become an increasingly talked-about issue amongst UK investors as fund managers are crowded into a small pool of stocks generating the most amount of income.
The UK market is one of the highest yielding in the world and as such is a natural destination for income-hungry investors.
However, due to the make-up of the market it can mean that investors are taking on some dividend concentration risk that they may not be aware of.
Indeed, last year 85 per cent of total UK dividends came from the FTSE 100, according to the Link Group Dividend Monitor, with the remained 15 per cent spread across the mid-cap FTSE 250 index and the small-cap space.
UK dividend distribution in 2019
Source: Link Group UK Dividend Monitor
Chelverton Asset Management’s David Taylor said there is “absolutely massive” dividend concentration risk going on in the UK equity income space.
Taylor, who manages the £714.4m Chelverton UK Equity Income fund, said just five companies make up 33 per cent of all UK dividends: HSBC, Royal Dutch Shell, Rio Tinto, BP and Royal Bank of Scotland Group.
Running a small- and mid-cap equity income fund Taylor said he stays away from the large cap stocks that appear in the portfolios of many of his peers.
“We’ve got 90 odd stocks, we’ve got 24 different sectors – look at the big cap income funds, they’ve all got the same stocks just in different levels,” he explained. “You know everyone’s got BP, everyone’s got Shell. So, it just enables us to diversify portfolios.”
Taylor said that when it comes to income stocks are are often cyclical and what can start off as a high yielder can see its dividends cut.
“Over the years, unfortunately what a lot of income managers have done is started off with an income fund and then kind of morphed into a sort of growth fund because they’ve held all their favourite stocks and never sold them,” he said. “And then they wake up one day and they don’t actually yield very much because the income’s gone.”
So what are the alternatives for income-hungry investors?
Tom Naughton, manager of Prusik Asian Equity Income fund, said that UK investors worried about dividend concentration risk should consider an allocation to Asia, which is fast establishing a reputation for high payouts. Indeed, the region paid out $148bn combined, more than the $105.8bn paid out by UK companies.
Source: Janus Henderson Global Investors
The Asia Pacific ex Japan region had been one of the fastest growing markets for income until recently, data from Janus Henderson Global Investors noted, after underlying dividends fell by 0.2 per cent last year.
Naughton admitted that while there isn’t as strong a dividend culture as in the UK, that can actually be a big advantage for investors.
“In Asia investors typically aren’t interested in income,” he said. “The market is very much retail-driven and most of the investor base is either high net worth who tend to invest almost like retail investors or retail investors.
“Neither are really interested in income and because of that income stocks tend to be quite cheap.”
He added: “Part of the reason in Asia is you don’t really have a big middle class in most of the markets and therefore you don’t have that developed pension or investment schemes
“But I think as markets become more mature as they develop more savings for sort of middle class people to retire, that’s what drives the focus towards income.
“And it’s really domestic institutions and investors that force companies to pay high yields. Without that it’s less of a focus just because their shareholder base is very different.”
Naughton said ultimately he believes companies will move towards a more UK-style dividend culture and attitude towards progressive dividend policy but are “some years away from that”.
Another area worthy of consideration in Europe, which has a “vast hunting ground” for income-focused investors, particularly in the small- and mid-cap space, according to Montanaro Asset Management’s George Cooke.
Cooke, who manages the Montanaro European Income fund, said it makes sense for UK investors to look outside the domestic market for income.
“It gives you diversification,” he explained. “It gets you a whole new set of companies doing probably very different things to the companies that you own in the UK.”
Again though, there is less of a dividend culture in Europe than in the UK and that is something that investors need to be aware of.
“A lot of UK companies wouldn’t cut their dividend unless they’ve really got that gun to the head. It’s kind of the last thing you do, particularly if you’ve got a sort of yield hungry investor base,” he said.
“One thing we have to manage is that because a European company might say ‘we’ve got great demand, we think we’re going to grow next year, we want to build another factory, we’re going to cut the dividend by 10 cents’.
“So, part of the challenge of managing the portfolios is to make sure that it’s not full of companies doing that.”