The case for having a Global Equity Income sector is surely obvious: it offers a broader investment universe than UK Equity Income. But some high-flying funds have only a 10% allocation to countries outside Europe, the US and the UK. James Smith investigates why so many steer clear of emerging markets
A steady flow of global equity income fund launches over the past few years indicates this sector is eating into the market share traditionally enjoyed by UK income products.
On the face of it, the case for the asset class is clear: it offers a much broader investment universe, not just in obvious geographical terms but also for sectors. Global income funds have far greater scope to invest in technology, for example, one area where very few UK businesses pay much in the way of dividends.
This argument has gained support owing to concerns over yield squeeze in the UK market, where more than half of overall income comes from just a handful of the largest blue-chip names. (For a counter-view on this, see box below).
Many UK income funds were badly exposed when banks fell off the dividend register after the credit crisis and BP suffered from the Macondo spill in the Gulf of Mexico – and the marketers for global funds jumped in.
But while the global argument might seem obvious, it warrants deeper investigation, particularly on the subject of how global these products really are.
With global bond products, for example, many managers have genuinely embraced their mandate’s flexibility in terms of emerging market debt, particularly after the savage sell-offs that followed last year’s taper tantrum left valuations looking attractive.
The same cannot be said of global equity income products. A quick survey of the best-performing funds in the sector shows a clear skew towards the Western world: global income offerings from groups including Invesco Perpetual, Standard Life Investments, BlackRock, Newton and JP Morgan have an average allocation to the US, Europe and UK of close to 90 per cent, leaving very little exposure to the rest of the world.
Benchmark can play a part in this, with the commonly used MSCI World very much a developed index, including equities from 23 markets – including Australia, Hong Kong, Israel, Japan, New Zealand and Singapore in addition to the US and Europe.
In contrast, the MSCI ACWI (All Country World Index) includes the same 23 developed markets plus 21 emerging countries. At the end of May the index had a 49.03 per cent weighting to the US, 7.91 per cent to the UK, 7.16 per cent to Japan, 3.8 per cent to France and 3.72 per cent to Canada, with the rest of the world making up 28.39 per cent.
But while that would explain a Western bias on passive funds, a central part of the marketing spin for active global equity income offerings is their flexibility.
Changing global dividend picture
Are these funds genuinely global then, or should they be more accurately described as developed/Western equity income?
Before we answer that, it is worth looking at how the global dividend picture has changed in recent years.
Henderson Global Investors produces a Global Dividend Index every quarter and the latest report shows developed markets outpacing Asian markets in terms of income.
In the US, for example – still by far the world’s largest income region despite a mixed history of distributing cash to shareholders – dividends were up 25 per cent in the first quarter of 2014 against the same period last year, compared with a 7 per cent rise in emerging markets and just 5 per cent in Asia.
Much of this imbalance has been down to currency weakness, with the Brazilian real, Indian rupee, South African rand and Russian rouble all down considerably against the US dollar.
Henderson remains cautious on emerging markets as sources of income this year but, looking past the short term, it is important to understand that dividend cultures in the East are developing rapidly from a low base.
About 90 per cent of stocks in Asia now pay a dividend, for example – up from less than 50 per cent in the 1990s crisis period – and the average payout ratio in the region is up to 40 per cent.
According to the Henderson data, annual dividends in both Asia and emerging markets have broadly doubled since 2009 – from $60.9bn (£36.25bn) and $54.2bn to $125.9bn and $96.8bn respectively – although growth has tailed off in the past two years.
Elsewhere, Europe and Japan have shown fairly flat dividend growth and while the UK and US have seen distributions rise strongly – from £73bn to £102bn and $226bn to $340 respectively – the percentage rise is much less than in the emerging world.
Margaret Weir, who runs an Asian Income fund at Eastspring, Prudential’s Asian asset management business, sees a bright outlook for dividend growth in the coming years although she acknowledges certain countries in the region are further down the path than others.
“Looking forward, we see a decent cyclical tailwind for payouts as economies continue to recover, but also a more important fundamental shift in corporate culture as the benefits of paying dividends continue to be recognised,” she says.
Highlighting the range of dividend cultures, against the average Asian payout ratio of 40 per cent, South Korea’s is just 10 per cent, making a 1 per cent yield, while India’s is only a little better at 27 per cent and a sub-2 per cent yield.
“With India, the country remains at an early stage of growth and many companies prefer to use free cashflow to reinvest in areas such as research and development,” says Weir. “The same cannot be said of Korea – Samsung, for example, was recently named as one of the world’s worst offenders when it comes to cash hoarding. Of a $176bn market cap, the company has $46bn in cash and with a large number of shares bought back and held in treasury stock at cost, we estimate the true figure is above $60bn.”
“Encouragingly, a resolution tabled at Samsung’s recent AGM talked about developing a new dividend policy and we hope the company can spearhead an income culture throughout Korea in the coming years.”
‘Margin of safety’ approach
With such changes occurring, why are so many nominally global funds still focusing on the UK, US and Europe?
At Jupiter Asset Management, Sebastian Radcliffe’s Global Equity Income fund is based on the group’s tried and tested “margin of safety”approach, with a primary focus on valuation.
“In basic terms, we are looking to offer a sensibly constructed portfolio made up largely of quality stocks from around the world purchased at attractive valuations,” he says. “There are many ‘dividend aristocrat’-type companies around, particularly in the US, with multi-decade track records of growing their income distribution year after year.”
For Radcliffe, the power of income investing is clear, with good-quality businesses compounding dividends continuously.
“When designing the Global Income fund, we found it was hard to work out what was driving returns when looking through a sector or geographical lens,” he says.
“Instead, we opted to structure the fund using various style buckets – the majority will still be quality but we will also own some recovery names, growth businesses and more defensive high yielders if we see opportunities.”
Radcliffe’s portfolio is among those heavily skewed to the Western world, with just over 40 per cent in the US, 30 per cent in Europe and 10 per cent in the UK.
While acknowledging growing dividend cultures in Asia and emerging markets – and investigating broadening the portfolio – he often struggles to find businesses that meet his quality criteria. “Payout ratios are rising in many emerging countries and we are not wedded to a Western bias on the fund,” he says. “But many of these markets are dominated by the type of lower-quality businesses we tend not to own.”
Ben Lofthouse, manager of the Henderson Global Equity Income fund and International Income Trust, says portfolios with a developed market skew have outperformed more Eastern-oriented vehicles in recent years.
“As an income fund, we are seeking companies offering sustainable dividend growth and it remains the case that Western companies still have a better track record in this area than emerging peers,” he says. “Dividend cultures are growing in Asia and emerging markets and there are good yields to be found in areas like state-owned enterprises, but we still find more companies with an established history of distributing to shareholders in the West.
“That will not always be the case, however, and we feel this is where a genuinely global fund can prove its worth: if we like Brazil, for example, we can invest there; if not, there are plenty of opportunities elsewhere.”
At present, Lofthouse stresses solid yield and macro arguments for a developed market focus in global income products.
Looking at 2014 forecast dividend yields, Australia at 4.8 per cent, the UK at 3.9 per cent and Europe at 3.4 per cent call for a developed world skew.
While emerging markets also look relatively attractive on this measure at 3.1 per cent, Lofthouse says the fact that the region includes countries yielding very little means investors are forced into more defensive areas such as telecoms to find income.
“On the macro side, emerging growth is still looking uncertain, with Brazil and Russia expected to post sub-2 per cent this year and China coming down from 10 per cent to around 6 per cent,” says Lofthouse. “Currency issues are also problematic. If you take the real, for example, it has declined close to 50 per cent against sterling since 2011, so a Brazilian stock nominally yielding 5 per cent is not paying that much to a UK investor.”
With this less clear macro picture, Lofthouse says many investors have gravitated towards large global businesses offering diversified earning streams rather than domestic-facing names in emerging markets.
While Lofthouse’s open-ended Global Equity Income fund, which he co-runs with Andrew Jones, follows the usual Western pattern, his ex-UK International Income Trust is more broadly diversified, with 7 per cent in China, for example.
“There are certain things the UK does very well – consumer goods, for example, with Unilever, BATS, Diageo and so on – so not owning those gives us scope to seek opportunities elsewhere, in China for example,” says Lofthouse.
“Liquidity is also a consideration, with the open-ended fund at more than £700m and the investment trust at around £90m. There is less liquidity in emerging markets at present so if our Asian funds buy an attractive £1bn stock with a 59 per cent free float, which is not uncommon considering the level of family-run businesses in the region, that would be harder to own in the Oeic.”
Look beyond higher headline income
Looking at global income portfolios with a broader regional spread, Artemis Global Income has about 11 per cent in Asia and 22 per cent in non-eurozone Europe, the Middle East and Africa. However, manager Jacob de Tusch-Lec says macro, and therefore regional, factors are much less important than a few years ago.
While he continues to believe emerging market exposure can play a key role in global income products, especially with the US yielding relatively little, de Tusch-Lec says investors need to look beyond higher headline income.
“The US remains a frustrating market for income investors as the strongest economy with the best companies but a yield little over 2 per cent,” he says.
“While the dividend culture is improving and there is income growth on offer, share price performance has been so strong that annual dividend increases of 10 or 15 per cent are nowhere near enough to influence the yield.”
On emerging markets, like Lofthouse he says a Brazilian company nominally yielding 9 per cent may look attractive but it has to be seen in the context of a currency down 50 per cent over three years.
“That said, we continue to see logic in emerging market exposure within an income mandate, with many companies in the region, particularly in areas like telecoms, coming to the end of a long investment cycle,” says de Tusch-Lec.
“This should mean growth in payout ratios, and whereas Western companies starting to pay dividends are often ex-growth, emerging market businesses upping their distributions are typically just less capital-intensive than previously. Emerging markets do have a role to play but we would also highlight the additional risk and for funds based around sustainability of income, that has to be a consideration.”
Lazard Global Equity Income manager Patrick Ryan also has about 30 per cent of his portfolio invested across Asia and emerging markets, avoiding the defensive large-cap developed market skew of many of his peers.
“Broadly, our view remains that emerging markets continue to be an area with greater structural support for stronger GDP growth,” he says.
“Many of the reasons investors have generally been positive on emerging markets during most of the past 15 years remain in place. Government debt is low and falling and the trend towards strong growth in consumer spending has been remarkably resilient to the slowdown in GDP growth in these economies.
“In addition, emerging market companies are more financially productive than developed market peers in aggregate, generating a higher return on equity even with a GDP slowdown and declining commodity prices.”
Ryan says emerging market companies generate both a higher dividend yield and free cashflow yield than developed markets businesses, despite still reinvesting to drive growth.
“We tend to compare a company’s valuation to its financial productivity, its ability to generate strong returns on capital and free cashflow,” he adds.
“When we combine the consistently higher level of financial productivity in the emerging markets with its relative valuation, a 30 per cent discount to developed markets on a trailing price/earnings basis, it is not surprising the portfolio is heavily skewed towards the emerging world.”
While regional allocation on Threadneedle’s Global Equity Income fund is also determined by stock selection, manager Stephen Thornber says there are yield opportunities available in Asia that do not exist elsewhere.
“First up, there are areas where Eastern dynamics are simply more attractive than in the West, such as telecoms,” he adds. “Coming out of the crisis, many European telcos were over-leveraged and operating in an over-regulated industry but refused to cut dividends as they felt growth would recover. It failed to do so and many subsequently had to reduce distributions.
“In contrast, Asian telecoms businesses such as Digi.com in Malaysia and Total Access in Thailand offer our key attributes of income, growth in terms of earnings and dividend, and a strong balance sheet with little debt.”
Thornber says such stocks have also allowed him, as an income manager, to play key themes such as smartphone penetration in Asia, with names such as Samsung still the preserve of growth portfolios.
“Asia also has sectors you cannot find in the West, such as casino companies. We own SJM and NagaCorp, which give great exposure to the key theme of Asian consumption growth.”
Thornber has just over 17 per cent of his portfolio in Asia and says his team is always surprised that so many peers remain Western-biased. “Perhaps this is a function of many global income managers starting off as UK specialists and building out from there,” he says.
“Some managers may also be concerned about dividend sustainability in the East, but of three income cuts on my fund in recent years, two stocks were British and one French. For us, most Asian companies have strong capital discipline – a lesson learnt from the late 1990s crisis – with very little debt and the kind of financial and management conservatism income investors like to see.”
Thornber is underweight the US, finding better income opportunities elsewhere as the market still tends to favour share buybacks or dividends.
“While a dividend increase in the UK, Europe and, increasingly, Asia will tend to lead to a rise in share price, US investors typically see a company starting to pay income as a sign of it moving ex-growth,” he says.
“That is starting to change slowly, particularly with the recent neutralisation of income and capital gains taxes, but payouts are coming from a very low base.”
When it comes down to it, the much-vaunted wider opportunity set for global equity funds – whether managers choose to take advantage of it or not – is only worthwhile if it leads to superior outcomes.
As outlined in the box below, volatility across UK and global income funds is about the same, but more importantly for investors, performance on the latter is yet to outstrip the more limited peer group.
According to Trustnet data to 30 June, UK equity income funds produced average returns over one, three and five years of 15.7 per cent, 37.4 per cent and 103.2 per cent respectively, against 10.7 per cent, 29.7 per cent, and 90.1 per cent from the global sector.
While global income funds are a relatively recent development – only 12 funds have a five-year track record – this performance shows work to be done beyond the marketing clichés. A wider investment universe as dividend cultures continue to develop around the world could prove one way of boosting returns.
The case for UK income
While the global income argument has quickly become accepted, UK income specialists are understandably keen to argue their case.
Tineke Frikkee, who runs the S&W UK Equity Income Trust, is quick to dismiss the yield squeeze argument, pointing out that several markets are much more concentrated than the UK. In Spain, for example, the top five dividend payers deliver 85 per cent of market yield, with Santander alone contributing 39 per cent of the country’s dividends.
Switzerland’s top five account for two-thirds of yield, with Nestlé more than a fifth, and Australia and Germany are also both more concentrated in dividend terms than the UK.
“I can understand managers of larger funds worrying about concentration risk as they will struggle to get meaningful stakes in smaller stocks, but many [global products] simply end up buying Novartis rather than AstraZeneca, for example, where the growth profile is similarly slow,” she says. “When it comes down to it, criticism of yield squeeze adds no value – investors in our UK Equity Income Trust are paying us to pick stocks in one market and there are around 1,000 in the FTSE All-Share alone.”
For Frikkee, global income is an example of where a good marketing story has, perhaps, run ahead of reality.
“Looking at the bare facts, global income advocates talk up the fact these funds are more diversified than UK peers – and with many more stocks from which to choose, that is true. But the key question is whether this diversification is actually producing higher returns with lower risk,” she says.
“Our figures show average three-year volatility is broadly the same across UK and global income funds at 3.2 per cent, so greater diversification is not immediately translating into lower risk. Investors need to look past the sales story and focus on what they are getting in terms of risk and return. Global income funds may meet needs in both categories but it is wrong to assume they will outperform UK peers with lower volatility simply because the stock universe is broader.”