In the current low interest rate environment, many investors have looked to income strategies to maintain or increase the returns on their portfolios.
This ‘search for yield’ has driven strong asset flows in several areas of the market, notably higher yielding fixed income securities and dividend stocks. This has been a commonplace shift across investors from large institutional funds to small retail investors. After all, with investors convinced that interest rates can only rise over the medium term, bonds’ traditional place as the steady income generating asset of a portfolio is under threat. This means investors have been forced to look elsewhere to generate income in portfolios.
At Nutmeg, we whole-heartedly believe that income has its place in an investor’s portfolio. As the chart below shows, without dividends, £100 invested in the FTSE All-Share since January 1986 would be worth a paltry £545, compared with £1668 once dividends are factored in. Income remains an important return driver for portfolios, both in fixed income and equity allocations.
Source: Macrobond, January 1986 – 31st August 2016
However, we believe the current search for yield is driving investors to ignore the rising risks in some dividend equity strategies, potentially undermining the stability of future income many of these investors are seeking. And we are not alone – as recently as July 2015 the OECD warned pension funds against an ‘excessive search for yield’ in order to meet liabilities.
Chief among our concerns is the crowding that is seen within major income stocks. We analysed the holdings of the largest 10 UK equity income focused mutual funds (taken from both the IA UK Equity Income and IA UK All Companies sectors) and found that crowding is rife within the largest holdings.
Accounting for a combined £49bn in investor’s assets, we found that overlap in largest 10 holdings was high – out of a possible 100 holdings, only 16 were unique. 7 stocks were seen to be featured in the top ten largest holdings of 50% or more of the largest UK income strategies.
Some stocks featured more prominently than others – for example, Imperial Brands (Imperial Tobacco) was featured in 9 out of 10 largest holdings, with an average position size of 4.71%, whilst Astra Zeneca was featured in 8 out of 10, with an average position of 5.1%. BP and GlaxoSmithKline are one of the top ten largest positions for 6 out of 10 managers, whilst British American Tobacco, Shell and Vodafone appear in 5 of the 10 managers largest holdings. (Source: Morningstar as at 31st August).
Crowding risk is often underestimated by investors, but it increases stock specific risk within portfolios, and can cause significant price depreciation when momentum and sentiment turns. This stock specific risk is increasing, as traditionally stable dividend paying companies come under significant pressure to reduce costs, or simply run out of cash to pay dividends at the current levels.
In the past year alone Rolls Royce has reduced its dividend by 50% and Rio Tinto has abandoned its promise not to cut its dividend. There are questions over the stability of the dividends from Shell and BP, and with miners such as Anglo American and Glencore having frozen dividend pay outs last year, income investors have a smaller universe of stocks to choose from.
Furthermore, investors who have bought different income strategies in search of diversification are at risk of being significantly less diversified than they expected. This, in part, is also being driven by the rules governing funds inclusion in the UK equity income sector. With the rules dictating that funds must have an income yield of at least 110% of the FTSE All-Share index, fund managers are increasingly looking towards the same higher yielding stocks as the core of their portfolios.
Dividend stocks are particularly susceptible to crowding risk in the current environment, due to low interest rates having made them particularly attractive relative to bonds over the past couple of years. Stable dividends have been seen as a good alternative to bond income, and many market participants have chosen to own dividend equities as ‘bond proxy’ assets in portfolios.
However, when interest rates normalise, pushing yields on bonds up, we expect investors to move assets back into bonds from ‘bond proxies’, putting selling pressure on the most widely held dividend stocks. In fact, as we move towards the Federal Reserve potentially increasing interest rates, this can already be seen in some popular US high dividend stocks.
So how do investors reduce their risk?
We believe that, in a crowded environment for dividend stocks, investors should be focusing on harvesting returns not just from income, but also from growth.
Income-focused investors can often overlook the growth aspects of a portfolio, but in an environment where higher income returns come at higher risk, growth is being undervalued.
Remember, an organic income is not the sole way of producing an income from a portfolio, and investors are able to compensate for lower yields by growing the underlying pot. We continue to believe that for income investors, as with all investors, a balance of income and growth return drivers in a portfolio reduces risk, and improves the probabilities of achieving the outcome an investor desires.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.
Macrobond, January 1986 – 31st August 2016
OECD warns pension funds over ‘excessive search for yield’ Financial Times, July 2015