Since 2007, average yearly council taxes are up 11 per cent; household electricity bills are up 30 per cent; the annual costs of running the family car and paying the family food bill are both up a staggering 60 per cent. And thanks to record low interest rates, the value of £10,000 invested in cash 10 years ago would have lagged well behind the rate of inflation, leading to a loss in real terms.
That last point is key for pension savers, or indeed anyone seeking to harvest income from their investments or concerned about maintaining their purchasing power in retirement. Thanks to years of low interest rates and rising income needs, many people face a real danger of falling short of their long-term financial goals, or quite simply running out of money as they age. Income-seeking investors have been forced to look beyond traditional sources to make up the shortfall.
A traditional favourite for investors seeking both capital appreciation and reliable income has long been UK equity income and the many funds available in that sector. However, there is reason to be concerned that even this trusty stalwart is and will be a less than viable source of income. In fact, figures suggest it is a shrinking and potentially volatile asset class.
Dividend growth among UK businesses is the slowest in more than three years as companies struggle with a relatively strong pound and a mediocre global economy. Excluding special dividends, the latest UK Dividend Monitor report by Capita Asset Services showed just a 1.4 per cent annual increase to £79.1bn paid out in 2014 – a decline in real terms (data as of January 2015).
What is more, concentration risk means that it has become dangerous for investors to rely too heavily on UK dividend income. In fact, in the fourth quarter of 2014, just three UK companies – Shell, BP and HSBC – made up three fifths of all UK dividends paid out. Obviously, it is news to no one that UK dividends are substantially reliant on a small handful of big companies, but what may be more timely is that two of those companies rely for their income on a commodity product that more than halved in price by the end of 2014. If we look back at recent history, BP also provided a graphic example of the pitfalls of this situation in 2010, when the suspension of its dividend alone caused a drop of nearly 10 per cent in the total UK dividends paid.
As shown in the illustration below, the vast majority of total UK dividends (more than 60 per cent) come from a small handful of companies, meaning that a UK equity income investor might inadvertently be overly dependent on individual company dividend payouts rather than having a diversified source of income.
Clearly investors should not restrict themselves to the limited opportunity set represented by UK equity income. Rather, they need to expand their income horizons globally across asset classes.
UK investors should consider seeking dividend income outside their domestic market, given the range of compelling opportunities elsewhere. Take the US for example, which is not historically perceived as having the strongest dividend culture. As shown in the chart below, the number of S&P 500 companies increasing their dividends is on the rise. In fact, 52 companies in the S&P 500 have a 25-year record for increasing dividends year-on-year.
And for investors who can extend their horizons to emerging-market dividends, the opportunity is growing there as well. In fact, nearly 800 companies in the MSCI EM index are now paying a dividend.
On a global level, there are currently 372 companies yielding 3.5 per cent or more. In the UK, there are just 37 companies yielding 3.5 per cent or more. In other words, there are 10 times the number of attractive dividend-paying companies globally than there are in the UK.
As another example, in the consumer staples sector, there are only six companies in the UK yielding 3.5 per cent or more, compared with 16 companies globally. In the UK, this sector shows some characteristics of a value trap and is dominated by companies such as Tesco that may have an optically high dividend, but in actuality could be vulnerable to cutting that dividend. Conversely, when we look at the consumer sector across global equities, it tends to be made up of strong multinational companies.
For investors who are ready to think globally, there are clearly compelling reasons to consider diversifying out of the traditional UK equity income sector. For example, income investors can access a range of income-producing assets by investing in multi-asset income funds. These funds expand the opportunity set beyond equities, with the flexibility to seek income-generating investments across multiple asset classes and across the capital structure.
Dividend-paying equities are not the only important source of income in a global multi-asset portfolio. Credit can also provide an attractive yield. For example, high-yield debt currently offers a relatively attractive yield, supported by strong corporate fundamentals and low default rates, and also provides portfolio diversification benefits.
Other examples of more unusual sources of income that can add value in the context of a diversified portfolio include preference shares and convertible bonds. In preference shares, some of the most attractive absolute yields on offer are represented by US banks. Convertible bonds can offer predictable income payments, while the hybrid nature of the asset class also offers asymmetric participation in equity markets. Across all these investments, balance and diversification remains vital.
In today’s tough environment, generating income depends on a broader approach that is more global than ever before. The key to generating a sustainable income stream is not simply to pursue the highest-yielding investments in the absence of considering risk and volatility. It is combining the most attractive risk-adjusted income sources into a global multi-asset income portfolio that pursues the returns that investors need through diversification.
For an individual investor with limited resources, access and expertise, choosing the right investment mix to generate returns without taking on too much risk is a high hurdle.
Furthermore, the professional asset allocation expertise that sits at the heart of multi-asset investing enables these funds to adapt to changing markets and economic cycles, while mitigating volatility. It also means they can look across the risk-return spectrum to deliver not just the highest yield in absolute terms, but the most optimal yield.
Talib Sheikh is a fund manager at JP Morgan Multi-Asset Income Fund
Key Points
Dividend growth among UK businesses is the slowest in more than three years.
UK investors should consider seeking dividend income outside their domestic market.
Other examples of more unusual sources of income that can add value in the context of a diversified portfolio include preference shares and convertible bonds.
