Many charities rely on income from their portfolios to meet their obligations but are also naturally averse to risk. Julian McCormack discusses how best to strike a balance between the two.
For many Charities, a key objective for their investment portfolio is to ensure sufficient income is generated to meet spending requirements. While we, as investment managers, strive to meet income needs, it is important to understand the risks associated with income investing and in today’s current environment it has become increasingly important to ensure sources of income are diversified.
‘Low risk’ assets provide little yield
Scope to diversify across asset class to obtain a healthy portfolio yield is becoming more of a challenge for investors. Traditional low risk assets such as cash and government bonds continue to offer little in the way of yield, leaving investors more reliant on potentially higher risk assets, such as equities, to achieve an attractive portfolio yield.
UK equities, for example, are yielding close to 4.5% and the yield on overseas equities is now pushing close to 2.6%. However, relying on equities as the principle source of portfolio income raises the importance of diversification within equities and spreading the income risk.
Be aware of UK equity ‘income’ concentration
Although the UK equity market has by far the most attractive dividend yield compared to other major markets, it is important to be aware of the income concentration at a sector and stock level. The largest three sectors generate over 50% of UK total dividends while the top five stocks equate to 36%.
It is therefore important not to get drawn into relying too heavily on one particular sector or stock for income. If for example, investors relied too heavily on Financials for income back in 2008, they would have had a nasty shock as the Global Financial Crisis unravelled. Banks and Financials accounted for 45% of UK total dividends and with many companies in the sector cutting dividends, portfolios would have seen a significant drop in income, as well as capital.
Similarly, relying too heavily on one particular stock would have been problematic. Over the last ten years, the two largest income paying companies, HSBC and BP, both cut their dividends in close succession, and the dividend sustainability of another large income payer, Vodafone is currently under the spotlight. Reducing the reliance on one particular sector or stock as a source of income is crucial.
Be aware of style bias
Another risk for income investors it to invest too heavily in ‘Value’ stocks, which tend to trade at a discount and as such, can quite often offer attractive dividend yields. ‘Value’ stocks, however, can underperform the market for sustained periods, as we have seen throughout the recovery from the Global Financial Crisis.
How do we, as investment managers, minimise this style bias risk and still achieve an attractive portfolio yield? Firstly, within an income portfolio we steer away from having a dividend yield threshold for stock inclusion. Instead we combine a mix of very high yielding stocks with those that have strong anticipated earnings growth potential. This balance still allows for an attractive portfolio yield while reducing style bias risk.
Secondly, we target stocks which have the ability to grow their dividend consistently over time. Many of the utilities, like National Grid, tend to fall into the non-dividend growing camp and although they certainly have a place in an income portfolio, it is important to compliment them with income ‘growers’. These will tend to offer more capital growth over time as the share price will reflect the growth in dividends over time.
Positive story for overseas equity income
A traditional equity income portfolio would have had a significant exposure to UK equities, given the attractive yield. However, overseas equity dividend growth has really taken off over the last ten years, growing well ahead of UK inflation. A large component of this growth has come from the US and in particular from large technology companies like Apple, which is growing it’s dividend steadily by 12% a year. Europe, Japan and other parts of Asia have all seen dividend payouts increase significantly. This is all good news for income investors who now have more of an opportunity to diversify across regional equity markets, again reducing income risk and of course capital risk. In a typical balanced portfolio we would now invest around 40% in overseas equities, accounting for around 20% of the total portfolio’s income.
Alternatives – a new source of income?
With cash and bonds providing little in the way of income, we are increasingly exploring Alternative investments. Alternatives cover a broad range of investments that do not fall into traditional asset classes and care needs to be taken when investing. However, with careful selection and appropriate due diligence, Alternatives can enhance the portfolio’s yield and help spread the risks to income. The likes of Infrastructure, Commercial Property and Private Equity are useful inclusions in a balanced portfolio.
Positive nature of equity income growth
Equity income has been the key driver of equity returns over the long term. Over the last 100 years or so equities have returned on average 5% year on year in real terms and of that, 4% is from dividends. On top of this, dividend growth is much more dependable in comparison to capital growth. Over the last ten years there has been only one year of negative dividend growth, unsurprisingly this was during the Global Financial Crisis when banks and financials, which equated to some 45% of total dividends paid, cut their dividends.
For those charities for whom income is a priority, although there are challenges, we still believe there is ample opportunity for a balanced investment portfolio to generate an attractive, sustainable level of income provided there is a focus on the quality and diversification of the income stream.
Julian McCormack CFA