Three reasons to diversify in the hunt for equity income

Obtaining additional income is the primary goal for many investors, yet achieving it can be hard. Here we look at three ways diversification can potentially bring wider opportunities for income-seekers who invest in shares:

1. Relying on just a few stocks for income can be risky – they may cut their dividends or the share price can fall
2. Some regions typically offer higher dividend yields than others
3. Sector opportunities can be very different in different regions

Reliance on single stocks can be dangerous

A “do-it-yourself” approach often seems attractive to investors: buy a handful of dividend-paying stocks and receive the income from these. There are many companies that have long track records of consistent dividend payments. These are often household name firms such as Coca Cola in the US or Royal Dutch Shell in the UK.

However, Shell is an instructive example. While it hasn’t cut its dividend in 45 years, it did introduce a scrip dividend as a result of the 2014 oil price fall. This means part of the dividend was paid in shares rather than cash. It only returned to paying the full dividend in cash in 2017.

This leads us to the first reason to diversify, and it’s the age-old cliché of not putting all your eggs in one basket. Just because a company has been a consistent dividend payer in the past does not mean it always will be in the future. Investors need to be sure that they have properly assessed the risks around a company (and its industry) in order to be confident that dividend payments can continue.

• For more on assessing the sustainability of a company’s dividend pay-out, see How safe are dividends

Expertise needed to calculate the risks

Conducting all the necessary research is a complex and time-consuming undertaking, so it’s no surprise that many income investors prefer to leave the heavy lifting to a professional fund manager.

Funds focused on equity income will invest in a range of stocks and will have a target income yield that they aim to deliver each year.

The theory is that holding a range of stocks leaves the overall portfolio less reliant on each individual company. If a few firms cut their dividends, or see their share prices fall, hopefully others in the portfolio will offset this by raising their dividends or otherwise performing better than expected.

Different regions offer varying yields

While there are many different types of fund to choose from, investors need to be wary of the limitations of focusing on a single region. A second reason in favour of diversification is that some regions have higher dividends than others.

The chart below shows the current dividend yields of various global regions, and how these compare to the average yields in the past. As we can see, there is a noticeable variation with US yields, for example, currently lower than those available elsewhere.

Many investors prefer funds that invest in their home market. This has the advantage of eliminating currency volatility. But it can mean missing out on the higher income or more diverse range of opportunities offered by other regions.

The charts below show, on the left, the weighting of each region in the global index, and on the right, the percentage of stocks in that region with a dividend yield above 4%. As we can see, Asia punches well above its weight on this metric, with just 12.5% of the index but over 40% of the 4% plus yielding stocks. By contrast, North America is over 55% of the index but has just 12.7% of stocks yielding above 4%.

Please note: Emerging markets, and especially frontier markets, generally carry greater political, legal, counterparty and operational risk.

Beware of sector skews

It’s not just a wider group of individual companies that is available to global investors, but a greater depth of sector opportunities too.

The chart below compares the sector breakdown of the global MSCI All-Country World index with that of the MSCI UK. There are some substantial differences, notably in information technology which makes up almost 20% of the global index but is so small in the UK that it’s included in “other”. Similarly, consumer staples is over 17% of the UK market but just over 8% of the global index.

The third reason for diversifying therefore is that holding a global equity income portfolio avoids the sector skews of any one particular region. It can also help to mitigate potential currency volatility, as the various different currencies will rise and fall against each other at different times in the economic cycle.

For investors seeking a diverse portfolio, it can make sense to take a global approach. But expert skills are likely to be needed to assess the potential risks and benefits of such a wide set of opportunities.

Rupert Rucker, Head of Income Solutions, says: “The challenge for the foreseeable future is that traditional sources of income, like bank deposits and government bonds, cannot fulfil investors’ needs. Investors can still earn attractive income but may want to consider other asset classes, for example equity markets. This is stressful. Diversifying investments globally can lead to reduced risk and potentially make income more reliable, but professional advice may be needed.”

- Click here for more information about the Income strategic capability at Schroders