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The weighting game

Arguably, the dividend yield on these shares is ludicrous even though it’s accepted as normal. As to why it’s ludicrous, consider that the average yield on the FTSE 100 index is about 4.3 per cent and on the wider All-Share index, which is dominated by the Footsie, it’s 4.1 per cent. Now compare that with UK inflation, running at 2 per cent – smack on the Bank of England’s target – or with the redemption yield on 10-year government bonds, which is 0.7 per cent.

The difference in those rates no longer causes a murmur, but an investor stepping out of a time warp from any decade of the 20th century and comparing them simply wouldn’t believe them; they would defy reason.

True, there was a time – before the ‘cult of the equity’ was established in the late 1950s – when it was normal for ‘risky’ equities to yield more than ‘safe’ government bonds. The flaws in that normality were exposed by a combination of post-War economic growth and rising inflation. In response, the ‘reverse yield gap’, whereby equities yielded less than gilts, became the new normal; so normal that ‘reverse’ was dropped from the label.

Since the global financial crisis we have returned to the situation where equities yield more than gilts even though equities have a mechanism – rising dividends – that both rewards growth and defies inflation and which is denied to fixed-interest bonds. Given that, one wonders why bother searching for yield in esoteric parts of the securities industry when yield is staring investors in the face from the blue-chip section of London’s equities? A payout that yields twice the current rate of inflation and six times what’s available from 10-year gilts and which will grow almost certainly at the prevailing inflation rate over the coming years seems plenty. Indeed, it may be too much because it can distort judgement, especially for those running portfolios for income, since it shunts them towards lower-quality companies.

As to why it has this effect, let’s look at the table, which breaks down where the yield on the FTSE 100 comes from. A full version of this table, showing the contribution of each component of the index, is available online.

First, note the way in which the 10 biggest components – the first decile – dominate the FTSE 100’s returns. These 10 account for 48 per cent of the index’s value and 53 per cent of all dividends paid in the past 12 months. Given that the 10 contain five stocks that each yield over 5 per cent – and that the two biggest components alone, Royal Dutch Shell (RDSB) and HSBC (HSBA), each yield over 6 per cent and account for 22 per cent of the index’s dividends paid – then there is little wonder that the yield on the FTSE 100 should be so high.

FTSE 100 dividend yield breakdown by market capitalisation
Mkt cap'nWeighted yield (%)Unweighted yield (%)Median yield (%)Mkt cap weightingPercentage of div's paid
1st decilena4.64.94853
2nd decilena4.34.41718
3rd decilena3.82.6108
4th decilena5.35.377
5th decilena3.02.443
6th decilena1.82.241
7th decilena4.02.633
8th decilena5.04.133
9th decilena4.85.122
10th decilena4.95.322
Whole index4.44.13.6100100
Source: S&P Capital IQ

Which leads back to the notion that this bias towards high-yield stocks in the FTSE 100 can lead to a loss of judgement by investors. That’s partly a result of the way in which stock market values are calculated – their averages are weighted by the market value of each component. This is logical when studying the index itself, but it makes difficulties when comparing the index with the performance of private investors’ portfolios (and often institutional ones, too) whose weightings won’t be remotely similar.

For a more realistic comparison between a typical equity portfolio and the FTSE 100, it may be better to make the contrast with the Footsie’s unweighted average (currently 4.1 per cent). It might even be reasonable to ditch average values altogether and focus on the median – ie, the mid-point – value (currently 3.6 per cent).

If that figure became the threshold for a high-yield stock, then the reservoir of stocks from which an income portfolio could be trawled would become usefully bigger. Currently, for example, the yield criterion for stocks going into the Bearbull Income Portfolio is 1.2 times the yield on the All-Share index. If that 1.2 times multiplier were applied to the FTSE 100 index, then only 33 stocks would qualify. Yet if the median value were the threshold, then 50 stocks would be available, the reservoir from which to trawl would be 50 per cent bigger, their yield would still be perfectly acceptable for an income portfolio and – this the key – the quality of companies from which to select would be substantially improved. Apply that notion to the whole London market and suddenly it looks a much better place for selecting income funds.