Worried about a UK dividend crunch? Diversify your income

On the surface, the outlook for the UK dividend market looks fairly rosy, particularly given that income payouts are forecast to hit a record high in 2017.

But a look under the bonnet suggests not everything is working as efficiently as it should be. The predicted bumper year for dividends is not being driven solely by the fact that companies are seeing their profits surpass expectations and in turn are handing back excess to shareholders in the form of income payments. 

Instead, the reality is that income investors have been given a big helping hand by the weak pound, which despite recovering its poise somewhat over the past three months is still 13 per cent below where it was versus the dollar prior to the EU referendum. The fall in the pound has the effect of boosting dividends, as many firms declare their dividend payouts in dollars or euros.

This is not the only worry on the horizon. Another concern is that the UK stock market is heavily concentrated, with the top 10 shares in the FTSE 100 paying around half of all dividends for the entire UK market.  

In addition, research by Henderson Global Investors highlights that on average 70 per cent of UK equity income funds hold all of the top 10 stocks  – so fund managers are heavily reliant on those dividends continuing. 

The trouble is that the vast majority of the big dividends are being paid by banks, miners, oil firms, pharmaceuticals and tobacco companies. Each sector is arguably challenged in one way or another. In last couple of weeks, for example, some of UK’s largest companies and popular dividend-paying shares such as AstraZeneca (AZN) and British American Tobacco (BAT) have suffered on disappointing news.  

As Adrian Lowcock, investment director at Architas, points out, the impact has so far been seen in falls in the share prices of the companies; at present the dividends on these stocks are unaffected. 

But he adds: ‘The volatility in a few shares should act as a reminder to investors that the UK equity income sector is fairly concentrated, with fund managers reliant on a small number of larger payers.  UK equity income funds have also lagged the wider market over the past two years, with the sector average fund delivering a total return of 18.3 per cent, versus the FTSE 100 returning 21.7 per cent.

‘UK dividends are concentrated in a handful of sectors including tobacco, pharmaceuticals and oil producers – mature industries for the most part, where dividend growth is achieved through cost savings and efficiencies. This concentration of income makes UK investors more vulnerable to stock specific risks and dividends cuts from individual companies.’ 

Below, with the help of Lowcock, we run through five ideas to diversify your income.

-For more ideas on how to invest off the beaten income track, check out our August edition of Money Observer, on sale now.

Think smaller

There’s something of a misconception that small shares are less generous income payers, when in fact in terms of dividend growth, small-sized shares tend to outperform their large peers.

Lowcock tips MI Chelverton UK Equity Income, a Money Observer Rated Fund. Another option to consider is the Money Observer Rated Evenlode Income

Go global

Global equity income funds also merit a closer look. But bear in mind that some of the funds in the sector have big weightings to the UK. A fund that has more than 8 per cent will be 'overweight' relative to the MSCI World index; some, however, have up to three times more than the index weighting.

This is a concern due to the composition of the UK dividend market, which is heavily skewed towards a handful of stocks. As holders of global equity income funds are likely also to hold UK equity income funds, there is the risk of a lot of crossover, with the funds holding the same companies.

Lowcock likes the look of Schroder Global Equity Income, also a Money Observer Rated Fund. Other Money Observer Rated funds with a low weighting towards the UK include Artemis Global Income, Murray International investment trust and Fidelity Global Dividend.  

Property and infrastructure

‘Commercial property benefits from having different characteristics from shares, and over the longer term has been an excellent diversifier,’ points out Lowcock. In addition, he adds infrastructure has also proven its defensive worth across various market cycles. He named First State Global Property Securities and the John Laing Infrastructure fund as his two choices.  

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