Over 50 per cent of UK dividend income is produced by only five companies, which results in a high overlap of stocks among UK equity income funds. So investing in a number of different UK equity income funds might not achieve the level of diversification you expect. Also, when one company cuts its dividend it can have a major impact on a fund - just look what happened when bank dividends dried up during the financial crisis and when BP suspended its dividend. Both of these factors reinforce the need for UK investors to look further afield for some of their equity income.
The number of global equity income funds has grown in the past few years, as have Asian funds. Some of these have successful track records, as evidenced by notable examples in the IC Top 100 Funds such as M&G Global Dividend (GB00B39R2M86), Murray International (MYI), Aberdeen Asian Income (AAIF) and Newton Asian Income (GB00B0MY6Z69).
Read more on Asian equity income
However, in recent years, a new category has appeared: emerging market equity income. Emerging market companies are increasingly recognising the benefits of paying higher and rising dividends, and can offer sustainable and growing income, with the potential for long-term capital growth.
Income-bearing shares have increased in emerging markets, with 23.4 per cent of shares in the FTSE World Index that yield more than 3 per cent now located in emerging markets - the largest proportion. For Europe ex UK the figure is 22.9 per cent, and in the UK only 7.3 per cent, according to FACTSET, Datastream, as at 30 June 2012.
Over the first 12 years of this century, emerging markets were one of the regions where dividends contributed the highest proportion to total returns, and they have also seen the highest dividend growth over this period.
Emerging market equities have materially outperformed the FTSE 100 over the decade to the end of May 2012, and high-yield emerging market equities have outperformed the broad MSCI Emerging Markets Index.
"Emerging markets are where the money and growth is," says Jason Pidcock, co- manager of the Newton Emerging Income Fund. "And in Asia, you find the nuggets others miss. For example, we are overweight healthcare because in Asia and the emerging markets this is a fantastic, long-term proposition as people are living longer, have more money and lifestyle-related illnesses. Hospital operators are a good investment." Portfolio examples include South African-listed Life Healthcare Group Holdings, which accounts for 3 per cent of assets.
Emerging markets equity income is also a good way to diversify within your emerging markets allocation, as beyond Brazil, Russia, India and China (BRICs) there are also many investment opportunities for equity income investors in Latin America, South East Asia and Africa.
Emerging markets include a number of high-growth economies with the potential for high earnings growth, adds Mr Pidcock. Young growing populations in the region provide a tailwind for growth and strong consumer demand from rising wealth.
Emerging markets are quite inefficient, so it is possible to find good profitable companies, and smaller companies with a lot more potential for growth than those in developed markets, according to Edward Lam, manager of Somerset Emerging Markets Dividend Growth Fund. Quality consumer shares trade at premiums just as in developed markets, but it is possible to pick up shares at much lower multiples. "There are pockets of value," he says.
Recent acquisitions include Turkish textile producer Aksa Akrilik, which was trading on a price-earnings ratio (PE) of 5.8 times.
Income-type investing in these markets has done well. "Over time, value investing tends to outperform in emerging markets, and value and income sometimes overlap," adds Darius McDermott, managing director of discount stock broker, Chelsea Financial Services.
A company needs to have reasonably good corporate governance to be able pay a dividend, so these tend to be better managed.
Over time there could also be currency support if emerging markets currencies strengthen.
While global equity income funds have the potential to invest globally, typically they do not have large emerging markets exposures, but rather a heavy weighting to the US and UK. But emerging markets equity income, on average, yields more than US shares.
Exploiting the growth of emerging markets consumers, an area on which Sophia Whitbread, co- manager of Newton Emerging Income Fund, is very positive on, is easier for income investors via emerging markets than Asian shares. "It is more difficult to find consumer companies with yields in Asia," she says. "Though as well as south and central America, we like south east Asia. Telecoms are a natural way to play domestic consumption."
Portfolio holdings include Philippine Long Distance Telecom, which accounts for 3.2 per cent of assets.
Although markets have been falling recently, some see this as a possible opportunity to get in at more reasonable valuations. "Markets are in a rough patch and this will continue," says Mr Lam. "It is a negative trend, but with a contrarian hat on there will be buying opportunities."
Buying markets when they are out of favour can be a sensible strategy, according to Jason Hollands, managing director at Bestinvest. "There is little doubt that emerging market equities are starting to look cheap," he says. "For a long-term investor, this probably does represent an attractive entry point. However, in the medium term we remain concerned about China's long-term growth rates and that means some form of discount on emerging market share prices is justified."
Risks
Higher returns are often accompanied by higher risk. Emerging markets can face increased political, regulatory and economic instability, less developed custody and settlement practices, poor transparency and greater financial risks. Their currencies may also be more volatile, and could detract from returns in the short term, while the shares can be harder to buy and sell, making them more volatile.
Dividend policies can be less robust, though active managers try to invest in companies with good policies.
Although emerging markets should appreciate in the long term, managers are cautious on the near term.
"We retain a cautious outlook for 2013, with market trading likely to remain dominated by developed market headline risks," says Ms Whitbread. "In South Africa, for example, we expect that some macroeconomic tailwinds, such as growth in social grants, will diminish in the future due to budget constraints. However, these tailwinds are unlikely to become headwinds in the next few years."
Mr McDermott says that while emerging markets income-paying shares can be lower risk than some others, lower-risk investors shouldn't have exposure to emerging markets. Investors should have an investment horizon of five to 10 years, and a higher-risk appetite, and hold emerging markets funds as part of a balanced portfolio.
For the equity section of a portfolio, emerging markets and Asian equity income could account for up to 20 per cent of assets, according to Mr McDermott.
With market volatility, Mr Lam suggests investors could invest regularly rather than put in lump sums, as it is difficult to time markets.
