Balanced income portfolios avoid the usual suspects

With banks offering derisory rates of interest on deposits and many UK gilts delivering a negative real return after tax, income investors are left with an unfortunately recurrent dilemma: where are the reliable streams of income to be found?

In the hunt for income, even bond managers will concede that this is an incredibly difficult environment for fixed income investors. UK equity income remains an obvious option, but for investors wishing to gain exposure to a well-balanced UK equity income portfolio, it is not all about fishing in the same equity pools for high yields.

When looking at the construction of a UK equity portfolio, most investors will head down the well-beaten route for income – juicy yields often grouped at the top of the FTSE 100. The bog-standard UK equity income fund will typically be skewed towards the top-10 stocks within the FTSE 100, merely because these firms comprise a large component of the index. There is little heed paid to portfolio balance and the potential for growing dividends.

It might feel counterintuitive, but there is sound reasoning behind taking a different approach. Even some very experienced investors believe income investing is simply buying the stocks with lots of income. That is far too prosaic, however, and too simple a strategy to apply to a market that is constantly changing and evolving – a landscape where today’s FTSE darlings may well turn out to be tomorrow’s laggards.

Ultimately, equity income investing is about building a portfolio through a combination of different types of stocks that will deliver a reasonable level of income, a tolerable level of risk and the prospect of growth.

Investors can avoid bias in the structure of an equity income portfolio by equally weighting all stocks. This means every stock in the fund can contribute meaningfully to returns.

This means avoiding some of the classic income plays.

Many seasoned income investors may get nosebleeds when they move away from the familiar surroundings of sector giants such as Vodafone and GlaxoSmithKline, but the reality is that beyond the FTSE titans, there are plenty of interesting ideas, and they are accessible without having to stray into the riskier, illiquid world of small caps.

A number of more specialist businesses have the ability to grow their income payments quickly. The engineering and tech sectors could be interesting for income investors looking to construct well-balanced income portfolios as they offer an eclectic mix of stocks. Innovative engineering businesses such as Rotork and Spirax-Sarco Engineering are prudently growing their businesses on a global scale but also growing their dividends. These are areas of the market that are habitually avoided by most British fund managers, although they represent some of the most compelling opportunities.

It may not be conventional wisdom when it comes to UK equity income investing, but blending stock selection and looking beyond the traditional big dividend payers can provide more sustainable and balanced income streams. An income investor with consistent long-term investment objectives should not necessarily think: “I must seek the highest yielders today, but question who will be the dividend payers and growers of the future.”

An income portfolio should hold a selection of stocks that together offer a combination of yield, capital protection and the prospect of growth, instead of just income alone.

Jeremy Lang is a partner at Ardevora