InvestmentsMar 21 2023

How to create diversified equity income exposure

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by
How to create diversified equity income exposure
Photo: Alaur Rahman/Pexels

Kamal says record-low bond yields, combined with meagre yields offered by many of the top-performing equities of the past decade, has meant running a portfolio with income in mind was uniquely challenging, especially relative to previous decades.

He says: “Three years ago, if you wanted a yield of 4 per cent on something, you might have had to buy the bonds of the government of Madagascar. But it is better now.”

Growth is the new oil, and in that context, paying slightly higher valuations may be justified.Fahad Kamal, Kleinwort Hambros

In terms of his equity exposure, he says: “The 60/40 equity-bond split is probably back. We are quite cautious on the outlook in general. But in our income portfolios we have been reducing our US exposure, and buying UK and European equities quite a lot.

"And that’s the key to outlook now: those markets both look reasonably priced and are also the markets that offer a decent yield. That means income investing is viable again.”

Preserving capital

One approach taken by some professional investors has been to take income from the capital gains made during a bull market. 

However, Eugene Philalithis, multi-asset investor at Fidelity, says that while very high yields from equities have been hard to come by, he focuses on “preserving capital” and owning lower-yielding equities that can grow the income over time. 

He says achieving 4 per cent income from an equity portfolio is now much easier than it has been for years, “but there is also much more volatility and uncertainty.” 

David Coombs, head of multi-asset funds at Rathbones Unit Trust Managers, says he tried to thread the needle by, “buying stocks such as US technology businesses that were going up a lot, and then using the capital gains from those to buy bonds which have a yield.

"What has changed over the past year is that more equities pay a decent yield, so we don’t need to own as many of the growth-type equities”.

He says the principal way his income portfolios differed from the more balanced strategies he also runs is the income strategies tend to contain more bonds and fewer equities. 

But he says changing demographics are also changing the long-term equity composition of a multi-asset equity portfolio.

Coombs says clients may in the past have expected to live for 10 years in retirement, so constructing a multi-asset portfolio meant focusing solely on income-generating assets to fund that lifestyle, but as clients live longer in retirement there becomes a need not merely to own income-paying assets, but also a slug of assets that can grow the overall size of the portfolio to deal with the additional years in which the portfolio will be active.

He says this may mean that over the longer-term, multi-asset income portfolios will also need to have some growth equities in order to increase the overall size of the pot.

James Klemptser is deputy head of multi-asset funds at Liontrust. He says taking income from capital tends to suit certain clients, specifically those that have a “target number” in mind for how much they want to withdraw from their portfolios annually. 

He says clients should always check whether their investment manager is achieving an income return from capital gains. Klempster says he prefers not to do this, and to use alternative asset classes to generate a natural income if one cannot be obtained from equities. 

Bird in the hand

Guillame Paillat, multi-asset investor at Aviva Investors, says that in periods when growth stocks that are not income payers are performing well, “it is better to own them, even if it means paying income from capital gains, than it is to lose money on the income-paying stocks that fall in value”.

Kamal says: “Thirty years ago almost every stock paid a dividend, now a lot of them don’t, so it can’t be just about focusing on the size of the income.

"I would also say that we may be entering a period of time where economic growth will be very rare and hard to come by.

"Growth is the new oil, and in that context, paying slightly higher valuations may be justified."

Paillat is another investor who is cautious on the outlook for global markets, but he takes the view that equities in areas such as healthcare can be both defensive and dividend paying. 

Michael Walsh, a multi-asset investor at T Rowe Price says the income/growth trade-off in equities also has a structural element. 

This is because, he says, many of the best income-paying stocks on the market right now are “traps”, as they are not really growing and eventually will have to cut their dividends.

With this in mind, he says paying income from capital gains may sometimes be the wisest course. 

Kevin Thozet, part of the investment committee at Carmignac, says the key for equity income investors will be to have more diversification, which “means more of the very high-yielding stocks and more of the high-growth stocks.

"Many stocks have suffered as a result of higher interest rates and bond yields, but the mistake would be to just buy the equities that benefit from that; if rates and bond yields are cut from here, then it would be best to own a different set of equities”.

david.thorpe@ft.com