Volatility in the developed world has meant sourcing income has dried up, prompting investors to turn their sights towards the opportunities afforded to them in the increasingly fertile world of emerging market income
Where now in the search for income? You may be surprised to discover an increasing number of investors are pointing their gaze towards emerging markets.
This is because the belief that income and emerging markets are a potentially snug fit is rapidly gaining credibility – emerging markets can offer extensive benefits for those seeking to diversify their income pool.
Although emerging market investments have traditionally been more volatile than those in developed markets, many companies in emerging markets have considerably revised their approach to investment and dividends, meaning the gap between developed and emerging market income potential is closing. Emerging market companies in the MSCI Emerging Markets Index have lowered their debt levels, increased profitability and maintained their growth ethos while keeping strong dividend payout levels.
This has helped emerging market companies to significantly outperform the FTSE 100 on a total return basis (when income and capital growth are combined) over the past 10 years – with high-yielding emerging market stocks performing even better – as they close the dividend payout gap with established developed-world sources.
The changing face of emerging markets for income
Historically, global emerging market companies have been prized for their ability to deliver capital growth for investors willing to take a higher risk, but an increasing number have evolved in recent years into steady income generators.
What has changed? In the face of more pervasive global scrutiny, many emerging market companies have increasingly taken a more disciplined approach. Improving corporate governance and a more disciplined management approach has led to falling debt levels, steadier cashflows and the feasibility of more sustainable dividends.
Much of this shift has occurred since the Asian financial crisis peaked in the late 1990s, when net debt levels for emerging market companies in the MSCI Emerging Markets Index averaged as high as 60% of their equity capital. These companies have trimmed these levels to less than 20% and have also generally kept their dividend payout ratios during this time in excess of 30% – a ratio achieved by a high number of companies, even during the difficulties of the recent economic crisis.
This shareholder-friendly emphasis may suggest a sustainable change in emerging market companies towards corporate discipline. Companies in the sector are already more profitable and less indebted than their developed market counterparts. And with a greater readiness and capacity to return profits to investors it could make them an increasingly attractive source of income going forward. However, from a risk element, companies in emerging markets often pay dividends in currencies other than sterling so UK investors can face some exchange-rate risk to the sterling value of any income.
Why diversify income sources?
One of the central tenets of astute investing is the need to diversify. In the UK, many investors receive their dividend income from traditional UK sources. However, as we have seen, the case is solidifying for investors to consider emerging markets as a viable and diversified source of income.
It makes sense when you look at the statistics: the top 10 dividend payers in the FTSE All-Share index now produce nearly 55% of the dividend income of the index, illustrating the traditional source for UK dividend income hunters is not very diverse. Oil, mining and pharmaceuticals also dominate – thereby increasing the risk exposure of a portfolio if pessimism sweeps a whole sector.
Emerging markets, on the other hand, offer income diversification across a wide variety of sectors and countries and while the risk factors are still there, there is more diversification. They are also more likely to be driven by faster growth and, unlike the UK, are not hampered by large public and private sector debt and rising taxes.
Why not consider investment trusts for emerging markets income?
The rationale behind targeting emerging market income to some extent is clearly becoming firmer but it is also worth exploring a popular way of doing so.
Investment trusts have, over the years, proved very adept at exploiting the profit potential of emerging markets but they also have many merits when considering their income potential in these regions.
Firstly, an investment trust can retain up to 15% of the revenue it receives in any one year by utilising its income reserve (open-ended funds must distribute all income on a given year). This facility gives investment trust boards the flexibility to draw on built up revenue reserves, to help investors ride out future income volatility and sustain or increase dividends.
Investment trust managers can also take advantage of their closed-ended structure and take a longer-term view without having to adapt to the potential of short-term, and often considerable, fund flows. This helps trusts accept companies in a portfolio that may be less liquid, but broadens the investment universe from which they can choose stocks – a trait that also helps managers be more active as they have the freedom to pursue (often rapidly growing) companies that lie outside of an index. Although, as a word of caution, holders of investment trusts themselves have to rely on there being a liquid market in their shares if they wish to realise their investment, which may not always be the case.
This approach of aiming to capture income from a wide range of sources, and with their growth emphasis still intact, may be a smart option for investors wishing to diversify a UK-biased income portfolio – and who may like a higher risk/return strategy to complement an existing portfolio.
Richard Titherington, chief investment officer of emerging market equities, J.P. Morgan Asset
Management
