The case for finding income outside of the UK

So, there we were last week, reasoning that there is an imperative for UK-based equity-income investors to put more of their capital into overseas stocks; the point being that UK value stocks – which is where high-yield stocks are most abundant – have become a gathering of pariahs and that assessment isn’t likely to change any time soon. Thus, if UK investors want more capital growth from their income funds, they have little choice but to look abroad; unless, that is, they’re wonderfully skilled or ridiculously lucky.

Granted, the idea of ‘equity income’ almost as a standalone asset class is peculiarly British, which partly explains why income funds tend to be loaded with UK-based companies. Sure, there are overseas dividend champions, such as Procter & Gamble (US:PG), which has increased its payout 67 years running, or Nestlé (CH:NESN), which has paid a dividend every year since 1959. Arguably, stocks such as these should form the core of an income portfolio, but for UK investors they rarely do.

A major reason for this is the difficulty of investing in overseas stocks. True, that does not apply to shares listed on North American exchanges (Canada included). This is thanks to the simplicity and effectiveness of the W-8BEN form and the administrative machinery behind it, which ensures that UK investors in North American companies receive dividends as free of local withholding taxes as possible. For shares listed on exchanges almost anywhere else, however, the bother of avoiding local taxes, or even arranging receipt of the dividends, is too often more trouble than it’s worth. Hence the advantages of going into overseas markets via funds whose managers in effect – and for a fee – take care of those tedious tasks.

Granted, on average, the leading overseas equity markets offer less dividend yield than the UK’s (see Table 1). Partly, that advantage is illusory since dividend income usually comes with a trade-off between the yield it offers and the multiple by which the distributing company’s net profit covers it. In other words, high dividend yields tend to come with lower dividend cover and, therefore, less security of income. So it’s probably no coincidence that, of the six major equity indexes shown in the table, the FTSE All-Share index comes with both the highest yield and the lowest cover. Meanwhile, the yield on the S&P 500 index of leading US stocks is conspicuously the lowest and its dividend cover the highest.

The contrast between those two indexes is a function of several factors. Go back to the 1950s and 1960s, and old rules in the UK meant retained profit was taxed more heavily than distributed profit. Thus UK investors got used to high levels of dividend, generating comparatively high yields, while US investors didn’t. Arguably, the extra sophistication of US capitalism also meant US bosses paid more attention to whether their company should be distributing net profit or reinvesting it internally, a question rarely asked in the UK. As a case in point, when did you ever see Warren Buffett’s Berkshire Hathaway (US:BRK.B) paying its shareholders a dividend? The great man contends – and rightly – that Berkshire will always retain its net profit while he is confident the group’s managers can use it more profitably than its shareholders. Allied to that – and coming to the present – the technology behemoths that dominate the S&P index pay little or no dividends.

That said, there are plenty of apparently high-quality companies whose shares offer both acceptable dividend yields and a compelling history of paying dividends. This applies both to the US indices and to those major markets where managing stock holdings is simply a chore too far; thus this week's focus on London-listed funds that both invest in overseas markets and offer high-yield levels of dividend. Because reliability of income is a prerequisite, the search concentrates on the globe’s developed regions – Europe, the Far East (including Japan) and North America, which, for reasons just discussed, is much less the priority.

By way of comparison, the chart and Table 2 also include City of London Investment Trust (CTY), which invests largely in UK companies (currently, they comprise 83 per cent of its £1.9bn portfolio). City of London is arguably the definitive UK value fund, at least of those funds easily available to retail investors. It has been around since the year dot (1891, to be precise) but, more importantly, has burnished its value credentials over the past 30-40 years. Since 1985, its total return comfortably exceeds that of the All-Share – its annual growth rate is 9.9 per cent compared with 8.7 per cent for the All-Share. The extra 1.2 percentage points are well worth having. Thanks to the wonders of compounding, they generate 50 per cent more value over that 38-year period than the All-Share.

And yet – and this is the chief point – as the chart shows, City of London’s performance over the past 10 years has been sad compared with the other investment trusts shown. As we can assume almost too easily, there was a parting of the ways between itself and the overseas funds in 2016 (Brexit) which was further widened in 2020 (Covid-19). Thus the annual growth rate in the total return of the three other trusts in the chart hovers around 8.7 per cent over the 10 years, while for City of London it is just 4.9 per cent. That’s comfortably more than the rate of UK consumer price inflation over the period, but that’s scant consolation.

Clearly, if the average income fund included a useful weighting from one or more overseas income fund such as those – say, 25 per cent in total – then the uplift to overall performance would be useful. And it’s not as though the trusts shown are short of income on offer. The lowest dividend yield is 4.4 per cent, offered by US-orientated BlackRock Sustainable American Income (BRSA), while JPMorgan European Growth & Income (JEGI) offers 4.5 per cent and JPMorgan Asia Growth & Income (JAGI) offers 4.7 per cent.

As to which of the overseas trusts shown is the best choice, it may not matter too much. It is noticeable that each of them has beaten its benchmark index, with the exception of Henderson International Income (HINT). That’s good to the extent it implies that it may be worthwhile for investors to pay for the active management that comes with these funds. But the underperformance of the £318mn Henderson fund is a pity since it is the only one shown that invests globally while ignoring the UK.

On a 10-year, there is little to choose between the performance of the Asian, European or North American trusts, although the Asian funds have had a comparatively hard time of it in the past year. In addition, they are the most concentrated of the trusts. At both the JPMorgan Asian trust and Invesco Asia (IAT), the top 10 holdings comprise approaching half their portfolios’ value. That implies their performance is likely to be more volatile than the trusts focused on Europe and North America.

All this said, there are other ways to skin a cat. I have paid no attention to open-ended actively managed funds, partly because I’m not keen on the open-ended model of investing but more because there are so many. Yet that still leaves exchange traded funds (ETFs) as a solution. For example, there is the intriguing possibility of bringing in one of two ETFs in the iShares stable – either iShares Edge MSCI World Value Factor (IWVU) or iShares Core MSCI World (SWDA). The former tracks a global value index and distributes dividends that currently yield 3.5 per cent (very acceptable); its limitation is that since inception in 2018, it has tracked the pedestrian progress of the FTSE All-Share index in a spooky fashion. The latter’s record puts it far ahead of even the best investment trust shown in Table 2, and it distributes dividends. The drawbacks are that it’s heavily biased towards US stocks (70 per cent of its portfolio) and only generates a 1.6 per cent yield.

No worries. As Baldrick used to say, “I have a cunning plan”. Hopefully, however, this one is sensible and I’ll roll it out later this month.

bearbull@ft.com