Are hybrid funds the answer to protect against external shocks such as BP’s dividend suspension? asks The Co-operative's Andrew Moffat
While the mainstream media has focused on obvious victims of BP’s leaking well in the Gulf of Mexico such as oil-covered birds and fisherman unable to work, the implications to investors are set to be equally far reaching.
Not only is the spill likely to result in a watershed in new environmental legislation, it will draw attention to flaws in the approach being taken by many of the UK’s most popular sectors to invest. It could even trigger a comeback for funds in a sector that investors seem to have long turned their backs on.
The disaster has caused two well-publicised issues for investors. The plunging share price, which has wiped over £50bn off BP’s value, and the company’s decision to suspend its dividend. It is the latter that could change Britain’s investment market.
The company’s fourth-quarter dividend last year was the highest of any UK company, making up almost 15% of the total yield of the FTSE 100. BP has generally been responsible for 12%-15% of the total yield of the FTSE All Share.
UK private investors will lose about £525m of income as a result of the suspension of just the first-quarter dividend. BP dividends are usually worth about £4bn a year to all UK-based shareholders.
The impact of the missed dividends highlights the difficulties income-seeking investors currently face. The companies paying dividends are highly concentrated in just a few sectors, typically utilities, pharmaceuticals, tobacco and banks. With banks rebuilding balance sheets, under pressure from the Bank of England and the FSA, many did not pay dividends last year. And they have been warned that with tough new standards on capital and liquidity due to be introduced later this year, they should be preparing now by setting aside more profits as a buffer – meaning it is unlikely that many will restart paying dividends any time soon. This has left a situation where just 11 stocks represent 60% of the dividends in the UK market.
Chasing income
Due to the popularity of UK Equity Income funds in the mid to late 2000s, there is over £28bn invested in the sector – all chasing yield from that same small group. Add in the over £22bn in funds in the UK Equity Income and Growth sector and that is over £50bn in collective investments alone which needs to be invested in equities with income in mind.
With BP and many banks out of the picture, high-yielding stocks such as GlaxoSmithKline are being touted as replacements but they are not without their own risks.
In the hunt for yield, fund managers often must buy stocks that pay a dividend but might not be sound investments. Not all dividends are sustainable, funded by debt rather than strong balance sheets and growing profits. Yield also does not always equal value – big yields can compromise capital. In the long term, a secure but growing dividend is preferable.
These high-yielding shares can also be susceptible to potential crises as is currently being seen with BP. Big pharmaceutical companies could be vulnerable to a disaster with one of their drugs, resulting in untold liabilities. Similarly, major tobacco companies could face further liabilities from claims for smoking-related health problems.
Other dividend paying companies are dealing with problems that could plague any company. National Grid is fighting with debt while Scottish Power, since taken over, had problems several years ago following over expansion. Many companies are struggling with their business models and their dividends are under pressure.
An alternative
In contrast to the £50bn in Equity Income and Equity Income and Growth funds, the UK Equity and Bond Income sector stands at just £3.4bn, according to the IMA, after years of declining sales. In the 12 months to the end of April 2010, the sector saw net outflows of £181m compared to a combined net inflow of over £1.8bn to the UK Equity Income and UK Equity Income and Growth sectors.
Hybrid funds such as these have lost out in recent years due to the popularity of fund of funds and multi-asset funds, as well as financial advisers becoming more hands on with asset allocation strategies, which tends to favour single-asset funds. The sector had 44 funds 10 years ago but just 20 today.
However, over the last 10 years, many Equity & Bond Income funds have generated significantly better returns than comparable asset classes even in periods of significant equity bull markets. Over five years some funds in the sector have seen returns of over 30%, significantly better than the median returns of the UK Equity Income & Growth sector at 23.1% and the UK Equity Income sector with 15.6%.
While UK Equity and Bond Income funds also seek income, they can utilise fixed income as well as shares to do so. Due to this greater diversity of income source, they have greater insulation to external shocks such as BP’s dividend suspension. Of the 86 funds in the UK Equity Income sector, 63 hold BP with 40 having the stock as their top holding – holding up to 10% of the fund in BP.
The fixed income component of an Equity and Bond Income fund serves as both a relatively low-risk anchor and as a source of income. It allows managers to be reasonably defensive in their equity selections – they do not have to take the large bets that managers in the Equity Income space do with stocks such as BP. Shares can be selected for their potential capital growth as well, rather than just for income.
Future sources of income
Although the UK sources of income have become scarce and the loss of BP’s dividends this year has been a blow, the dividend outlook is improving. Many companies have been rebuilding their balance sheets post crisis and recession, so are now in a position to restart paying dividends or to grow dividends.
The outlook for corporate bonds is also positive. While the lingering sovereign debt crisis in Europe could have further knock on effects on the corporate bond market, overall pessimism is also unfairly hitting strong companies. Many investment-grade bonds are offering yields well above 5%, with companies reporting improved earnings and cash flow – making it less likely they will default.
For managers able to tap markets beyond the UK, the US and Asia also offer opportunities for income from both shares and bonds. This is an option for UK Equity and Bond Income funds which can have up to 20% in non-UK holdings.
It is this greater flexibility to generate yield through a wider variety of sources, particularly the fixed interest market, that could help revive investor interest in the sector.
Andrew Moffat is fund manager of the CIS Income with Growth Trust
