Many equity portfolios will eventually be skewed to provide income – compounding the expectation of shareholder returns via the ‘good old’ dividend. These are important to all investors and provide a regular reward for having faith in the company. However, across an equity and funds portfolio it can be difficult to ascertain where income comes from, and, more important, how much comes from where.
Dividend concentration, and the risk of this becoming too high, is often overlooked. If too much of your income comes from too few holdings, there is a greater risk of having to deal with income volatility and shortfalls should one of those holdings fail to meet expectations.
This is an even greater risk when looking specifically at UK equity income and dividends. Payouts between April and July 2018 show concentration was worryingly high. According to Link Asset Services, a consultancy, 25 per cent of all dividends came from only three stocks: HSBC Holdings (HSBA), Royal Dutch Shell (RDSB) and Rio Tinto (RIO). Overall, the top 15 dividend stocks accounted for 50 per cent of all payouts.
Ryan Hughes, head of collectives research at AJ Bell, says market yields and high dividend payouts often hide wider concentration issues. “The FTSE 100’s dividend yield of 4.1 per cent for 2018 is tempting, but you need to look at the source of the dividends. Of the forecast payments for 2018, almost two-fifths is from just five stocks – Royal Dutch Shell, HSBC Holdings, BP (BP.), British American Tobacco (BATS) and GlaxoSmithKline (GSK) – and nearly half from the 10 biggest payers, including Vodafone (VD), Rio Tinto (RIO), AstraZeneca (AZN), Lloyds Banking Group (LLOY) and Glencore (GLEN)."
While it is important to have exposure to the biggest dividend payers, doing so at high levels could be dangerous. This is because should even one stock fail to pay a dividend, as seen with BP in 2010 when it cancelled its dividend to account for the Deepwater Horizon disaster, it would have a significant impact on your income portfolio. And this is before accounting for the impact a cancelled dividend would have on the share price.
“The UK large-cap market is quite concentrated. But it is not really a surprise when one considers that the biggest stocks in the FTSE are mature companies like HSBC, Royal Dutch Shell, British American Tobacco and BP. Mature companies that tend to have the surplus cash flows to pay high dividends,” says Peter Sleep, senior investment manager at Seven Investment Management.
“These large companies may seem relatively safe, but we have seen many times that they are not,” he adds.
Within your own portfolio, dividend concentration is relatively easy to calculate. First you need to work out the amount of income you receive from each holding – you can either get this from a breakdown provided by your platform, or by multiplying the basic dividend or coupon by the number of shares or units you hold in a company or fund. Once you have worked out the income paid by each holding, concentration is this figure divided by the total portfolio income, as a percentage. That will tell you what each holding is contributing as a percentage of your income, and you can judge whether you are too dependent on a low number of stocks or funds.
Mr Hughes adds: “If you have a high concentration you can still be happy taking this risk if you feel the yield on offer compensates you. You need to do your homework and look at each holding’s earnings cover, free cash flow cover, balance sheets and interest cover to help decide.”
How high is too high?
There is no definitive answer as to how much income one stock or fund should account for, and as with most aspects of investing it comes down to your risk tolerance. If you feel you can withstand a significant fall in income and capital value (as a dividend cut will likely be followed by a share price fall) then a concentrated income portfolio is fine. However, if not then diversification and reducing each holding’s concentration is vital.
It is also worth bearing in mind that you might believe you are diversified by number of holdings, but concentration could still be high, so it’s important to look at the income value of each holding, and not just the number of holdings. Concentration also has to be considered on more macro scales, such as sectors. UK equity income tends not to be very diverse when it comes to sectors, and this can be a problem should a particular industry, like oil majors, banks or miners, ever struggle.
“If you are a UK equity income investor, chances are you’ve got quite concentrated exposure to specific sectors like banks and oil," says Simon Moore, also a senior investment manager at 7IM. “Those sectors have traditionally paid the highest dividends. But this is not without its risks, as the 2010 Deepwater Horizon spill highlighted. Not only did it affect BP’s dividend, but many high-profile funds too. And if you want to see the risks of holding too many banks, look no further than the global financial crisis."
"There is no right level of diversification,” adds Mr Sleep. “Academics will suggest that you need at least 30 individual stocks to mitigate the risk of a single company blow-up.”
Doubling up with funds
The rules dictating how funds should be structured (in terms of limits on how much a manager can invest in one specific stock) tends to mean that equity income funds provide good diversification in terms of income. However, there are several aspects to consider here.
There is the perception that a combination of individual direct holdings and UK equity income funds counts as diversification. In the Investors Chronicle Portfolio Clinic, it is not uncommon to see investors with income portfolios holding major UK income stocks, and also funds, often missing the duplication. UK equity income funds are a great way to ensure diversified source of income, but they also only buy the same stocks investors can and do buy themselves.
For example, the most popular open-ended income funds in the Investment Association UK Equity Income sector by size are Artemis Income (GB00B2PLJJ36), Threadneedle UK Equity Income (GB00B8169Q14) and JO Hambro Capital Management UK Equity Income (GB00B95FCK64). The most popular investment trusts are City of London Investment Trust, (CTY), Finsbury Growth & Income Trust (FGT) and Edinburgh Investment Trust (EDIN).
All except FGT include at least one of the top 10 dividend-paying companies in the top three holdings. This is of course to be expected, and entirely logical. However, investors need to account for this when investing in both funds and direct shareholdings and ensure their portfolio’s dividend concentration risk is not amplified by large holdings, in for example HSBC and The City of London Investment Trust – which holds 4.5 per cent in the bank.
Top five holdings in largest equity income funds and trusts
| Fund | Top-five holdings |
| Artemis Income | BP, 3I Group, GlaxoSmithKline, Royal Dutch Shell, Relx |
| Threadneedle UK Equity Income | AstraZeneca, GlaxoSmithKline, Electrocomponents, Imperial Brands, WM Morrison |
| JOHCM UK Equity Income | Royal Dutch Shell, BP, HSBC Holdings, Lloyds Banking Group, Vodafone Group |
| City of London Investment Trust | Royal Dutch Shell, HSBC Holdings, BP, British American Tobacco, Diageo |
| Finsbury Growth & Income Trust | Diageo, Unilever, Relx, Hargreaves Lansdown, LSE Group |
| Edinburgh Investment Trust | British American Tobacco, BP, Burford Capital, Legal & General Group, BAE Systems |
Source: Fund factsheets, as at 31.07.2018
Investors should also be wary of using multiple income funds in the same geography, for two quite inverse reasons. First, if the funds have the same holdings your portfolio and income source will not be as diversified as you believe. Second, if the funds are entirely different, there’s a risk of overdiversification – which can result in returns being so diluted you lose the benefits of active management and above-index returns, but pay the cost of active funds.
Funds' dividend concentration
It is also important when choosing an equity income fund to look at its dividend concentration risk, to ensure you are satisfied with the risk being taken on. Funds can end up relying too heavily on too few stocks or specific sectors for income.
As it stands, only one fund, the Neptune Income Fund (GB00B8L7B355) run by Robin Geffen, highlights its dividend risk – publishing the proportion of income it receives from its top 10 holdings, currently 17.1 per cent, on its monthly factsheet.
However, investors should request this information from fund providers, according to Mr Hughes. “It can be difficult to fully ascertain the concentration level of dividends in an equity income fund, particularly when the fund invests away from the largest companies. The best way is to simply ask the fund manager in question. You are very much within your rights to contact fund managers and get the answers to the questions that you have.
“If a fund is very concentrated and reliant on only a few stocks for a large proportion of its income, then it is certainly a reason to be wary and maybe look to diversify your income exposure with funds that invest in other areas,” he says.
Other ways to reduce concentration
There are other simple ways to reduce dividend concentration, and the risk of this becoming too high. Investors should consider income from different regions, which reduces geographical correlations.
The other is by cap scale. In the UK equity market, 84 per cent of dividends paid between April and July came from FTSE 100 companies, 13 per cent came from the FTSE 250, with small-caps and Alternative Investment Company (Aim) stocks accounting for the rest.
It is clearly important to have large-caps for income – mature businesses are the most likely to distribute capital, but investors should spread the risk into mid-caps as well. Investing in the FTSE 100 alone will leave you focused on fewer stocks and with greater exposure to banks and oil stocks. In addition, Link Asset Services says long-term dividend growth has been higher among FTSE 250 stocks than those in the FTSE 100.
