Diversify your income with Asian equity funds

Goodbye UK, hello Asia?

Tilney Bestinvest says that around 57 per cent of the total UK dividend pot came from just 15 companies in the past fiscal year and that income is under threat at some of the UK's biggest corporates. In February, Centrica (CNA) saw £1.2bn wiped off its valuation when it reported a 35 per cent profit clump and cut its dividend to 30 per cent and Wm Wm Morrison (MRW) 2015-16 dividend was slashed to "not less than 5p per share" - a cut of up to 63 per cent on the 2014-15 payout of 13.65p.

That could turn around this year, with UK dividend payments ticking upwards in the past few months, driven by the strength of the US dollar, helping the companies that make payouts in that currency. But two years of weak dividend growth has left investors seeking diversification.

According to Legal and General's Asian Income Trust team, the top 20 companies in the UK pay around 73 per cent of dividends, whereas in the Asia Pacific ex-Japan region only 49 per cent of dividends are paid by the top 20 companies.

With a much wider pool to fish in and a large number of high-growth companies, there is a good chance fund managers investing in Asia will be able to achieve high yields. There has also been a cultural shift in the region in recent years towards better corporate governance and better understanding of the value of dividend payments for shareholder loyalty. Ben Yearsley, head of investment research at Charles Stanley Direct, says: "There is now much more emphasis from Asian companies on paying consistent dividends."

Tim Cockerill, investment director at Rowan Dartington, adds: "Capital growth should be greater than you would expect to get from a UK equity income fund."

Ben Yearsley, head of investment research at Charles Stanley Direct, agrees: "You are getting slightly better income than you are with UK funds and better growth over the long term. I'm very positive over the long term for both income and growth investors."

What's the catch?

However, due to Asian income funds' focus on companies with solid income growth potential, they are likely to take less of a part in upside rallies and be more defensive in nature than other Asian funds. This means that you may not experience the same dramatic highs as other, general Asia funds, but you could also be more protected on the downside.

Simon Dorricott, analyst at Morningstar says: "There is a benefit to having an income approach in these more volatile markets in terms of being able to highlight companies with good corporate governance and slightly lower beta (a volatility measure). You'd expect to have some steadier companies like utilities and infrastructure and will not have some of the real high growth stocks that reinvest all profits."

The risk

However, risk in Asian markets is unavoidable and you will experience some volatility. Mr Yearsley says: "You need to have a five- to 10-year investment term to ride out the fluctuations. If you can't cope with seeing a 20 per cent fall in a short space of time then don't invest in these funds."

Andy Parsons, head of investment research at The Share Centre, says: "The problem for me is that whenever there is market uncertainty it's a region that can sell off quite strongly and quite quickly."

The investment options

Before last week, Newton Asian Income (the cheapest version of the fund available is the W Inc share class with an ISIN number of GB00B8KT3V48) was the clear frontrunner in popularity terms among managers and investors. With assets under management of £4.4bn it was hailed as the 'behemoth' of the sector. But last week stalwart manager Jason Pidcock announced his dramatic departure to rival fund house Jupiter after nine years at the helm of the fund, sending shockwaves through the market and potentially altering the landscape for investors.

The fund has been a strong performer over the long term but had waned in the past two years. Since inception, it has delivered a return of 64 per cent compared with 35.9 per cent for the Investment Association Asia Pacific Ex Japan sector average and is currently yielding 5.32 per cent - one of the highest in the sector. However, in 2013 it slumped into the third quartile, and also underperformed its comparative index, FTSE AW Asia Pacific ex Japan. That was, in part, due to an underweight position in China and overweight in New Zealand, where a holding in Chorus, New Zealand's largest communications infrastructure company, hurt the fund with a 47.5 per cent share price crash at the end of 2013.

The shock exit of Mr Pidcock has led to many managers removing the fund from their watchlists or selling it. Ben Willis, head of research at Whitechurch Securities, says: "We had concerns over the fund's size, which led to us scaling back our exposure gradually. However, our belief in Mr Pidcock's ability and expertise in managing the fund was the main reason for maintaining our position. Now that he has moved on, we are selling our entire position."

Mr Yearsley says: "Newton takes a very team-driven approach and the team is still there. I don't think you need to rush out and sell the fund today." However, he acknowledges that he may be tempted to invest in Jupiter's new fund when it launches - probably not until next year.

In the meantime, he suggests looking to Schroder Asian Income Z Inc (GB00B559X853). The fund's largest exposure is to Hong Kong and Australian equities and, like Newton, it has manufacturing giant Taiwan Semiconductor Manufacturing as its largest holding.

The fund has posted strong returns in the past five years, returning 12.7 per cent last year and 7.4 per cent in the year to date, compared with around 9 per cent each year for the index. It has a yield of 4.39 per cent and has grown its dividends year on year even throughout the financial crisis, according to FE Trustnet.

Manager Richard Sennitt also manages the Schroder Asian Income Maximiser Z Inc (GB00B53FRD82), which uses a derivative strategy to boost its yield to a hefty target of 7 per cent per year. By selling 'call options' on certain stocks, in which traders buy the right to purchase securities at a set price within a set timeframe, the fund makes additional income on its portfolio.

The strategy of selling securities for a set price means that the fund can miss out if stocks appreciate dramatically. But Darius McDemott, managing director at Chelsea Financial Services, says: "You've got a solid starting yield of around 4 per cent and then you get a premium income on top of that." The fund has delivered lower returns when others have rallied, but performed well in 2013 when other funds delivered barely single-digit growth.

Mr Cockerill also likes Legal & General Asian Income I Dist (GB00B7XH5V20). He says: "It's relatively conservatively managed and has a good team behind it." It has a relatively high yield of 4.54 per cent and increased its final dividend in September 2014 to 7.636p, up from 7.099p in September 2013.

Investment trust options

Of the three Asian income investment trusts: IC Top 100 fund Aberdeen Asian Income Fund (AAIF), Schroder Oriental Income (SOI) and Henderson Far East Income (HFEL), SOI has been the stellar performer in the past two years while Aberdeen Asian Income (AAIF) has lagged behind.

SOI has beaten its peers in 2014 and in the year to date and also has an attractive yield of 3.79 per cent. Dividend growth has also been strong, at 7.5 per cent a year since launch in 2005, while revenue reserves of 5.7p (equivalent to 0.75 years' dividend), suggest Schroder Oriental Income's dividend is secure. Matthew Dobbs, who has managed the trust since launch, focuses on quality companies with strong balance sheets, sustainable earnings, cash flows and corporate governance - bought at attractive valuations.

All three investment trusts tend to trade at a premium, so buying at the right time is key. Currently SOI is trading at a premium of 1.05 per cent, a little above its 12-month average of 0.26 per cent, compared with Aberdeen Asian Income Fund, which is trading at a discount of -2.77 per cent, below its 12-month average of -0.21 per cent.

After several years of strong performance, Aberdeen Asian Income Fund has suffered two years of underperformance, falling by 9.9 per cent in 2013 and coming behind its peers in the year to date. Despite that, it has a high yield of 4.4 per cent and has increased its dividend each year since 2009.

Of the three, Henderson Far East Income has performed the worst over the long term, but it has been catching up in recent years. The fund has also grown dividends consistently in the past decade and currently has the highest yield of 5.31 per cent. However, the trust has the largest exposure to China and could be affected if a Chinese economic slowdown reduces dividend payments in the region.

Which fund offers the lowest risk?

In the past five years, the funds that have seen the largest drops from peak to trough are Henderson Far East Income and Aberdeen Asian Income. Henderson experienced a large drop in 2011 and was also volatile in 2012-13. When looking at Asian income funds, you should be prepared for large jumps from rally to slump.

If this concerns you, consider Legal & General Asian Income I dist (GB00B7XH5V20), which has tended to fall less than its peers. In 2014 Schroder Asian Income Maximiser suffered the least in a downturn. However, according to FE Analytics, it has not been consistently the best fund in terms of maximum drawdown - the largest peak-to-trough decline in the value of the portfolio.

The fund with the highest sortino ratio, according to FE Analytics, was Schroder Oriental Income in 2014. Sortino ratio is a measure of risk-adjusted return that looks at return against downside volatility. A higher ratio means you are better compensated for the large drops in total return.

Performance of recommended funds (%)

Note: Shows total share price return. * This share class has similar performance history to the cheaper W Inc version which only has a short track record.

Source: FE Trustnet and Morningstar, as at 21 May 2015

Top-yielding funds

Source: Morningstar, as at 21 May 2015