Look to Europe for income

As investors increasingly look outside of fixed income for the income component of their portfolios, European equity income has become a compelling option, offering diversification and a large pool of companies that have remained largely untapped in terms of their yield potential. For clients seeking the best the sector has to offer, the BlackRock Continental European Income Fund, managed by Alice Gaskell and Andreas Zoellinger, provides a strong yield, impressive capital returns and volatility substantially below the market.

“The aim of the fund is to generate a reliable, growing income stream in absolute terms,” explains Mr Zoellinger. “We do not target a set dividend yield, but we are targeting absolute dividend distribution that can grow over time. The reason for this is that at various points in the market cycle, the available income will become concentrated in riskier areas. If you think of the scenario in 2007, for example, when the yield in the market was quite low as the market was high, if you promised your clients, say, 4 per cent or higher dividend yield, you would have been forced to invest in areas of the market that were highly risky and volatile. Instead, we generate an income stream by investing in quality companies and we have a strong focus on reducing volatility.

“At the moment, we have 4.2 per cent net dividend yield since inception, 25.1 per cent cumulative return over the same period, achieved with 18 per cent less risk than the market. It is risk that is the main thing clients do not like and so we want to reduce it as much as possible.”

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One of the key benefits of opting for a European equity income fund rather than a UK equity income counterpart is it represents a much less concentrated income universe. Indeed, there are more than 100 companies within continental Europe that have a market capitalisation of more than €1bn and a dividend yield of more than 4 per cent. The equivalent for the UK is around 30 companies. Within that, while the top-10 dividend payers in the UK account for more than 50 per cent of all the dividends paid in the UK, the corresponding number in the rest of Europe is less than 30 per cent.

“For UK income investors the choice of income assets is much smaller and much more concentrated,” confirms Mr Zoellinger. “If you consider that Vodafone, which paid a very big special dividend after selling off the Verizon asset, is now having to halve its dividend payment going forward, the pool is getting even smaller.

“There is also a great deal of pent up demand and investors are not currently paying a premium for income stocks as European equity income is not a well-recognised asset class yet. To put it into the context of BlackRock, the UK equity income fund launched in 1984, the US equivalent in 1986, while the European equity income vehicle was not launched until 2010, with this fund following in 2011. There simply is not a strong tradition in the market of investing in European equities for income generation. It also allows for better diversification in terms of portfolio construction, achieving a better risk-return balance by combining UK-based and European equity income strategies.”

In terms of the types of stocks the managers look to include in the fund, the main strategy for reducing risk is to opt for high quality companies with a steady dividend stream. Quality is defined, in this instance, by a company having good earnings visibility, adequate balance sheet cover, strong corporate governance and good visibility that the dividend will be paid and, if possible, will rise over time.