We have long held the view that there is far too much concentration within the UK Equity Income Sector, with many funds having to rely heavily on a small handful of FTSE 100 stocks in an attempt to produce an acceptable yield. For example, our analysis shows that the average IA UK Equity Income fund takes a high level of dividend risk as it relies on its top 10 holdings to generate 43% of its yield. In our view, taking such an approach not only puts investors’ income on a weak footing, it also puts their capital at risk – the recent sell-off in equity markets has illustrated this dynamic.
The equally-weighted nature of the portfolio has been one of the major contributors to the Fund’s outperformance during the recent correction
The Neptune Income Fund, unlike the majority of its peers, is managed with an equally-weighted approach to portfolio construction – whereby every stock must meaningfully contribute to the Fund’s overall yield. The proportion of our yield generated by our top 10 holdings is therefore considerably lower than our peers, usually ranging between 15% and 30%, while the portfolio itself is diversified in terms of sectors, styles and our own in-house silos. This approach has enabled the Fund to deliver consistent outperformance (both in terms of absolute and risk-adjusted returns, as measured by the Sharpe Ratio) over one, three and five years relative to the FTSE All-Share Index and the IA UK Equity Income sector. Our approach, combined with our constructive view on global economic growth, has also meant that we continue to avoid overvalued ‘bond proxy’ stocks which investors have so heavily relied on for their earnings visibility in the QE era. Instead we remain focussed on valuation and companies with the revenue to support a growing dividend; we expect this approach to be of particular benefit to our strategy as yields and inflation pick up.
The clear and present dangers of overreliance
This means that recent dynamics within the UK equity market have been of particular interest, with this year’s correction illuminating many of the risks we had previously identified. US wage data spooked both bond and equity markets in January, with the accelerated growth leading many to expect more aggressive rate hikes from the US Federal Reserve. Though markets have begun to recover very recently, the FTSE All-Share lost 8.29% from peak to trough during the sell-off. Over that period (12 January to 9 February), the Neptune Income Fund was the third best performer in IA UK Equity Income sector, with a return of -4.85%.
...our analysis shows there was a direct correlation between the worst performing funds during the sell-off and those with the highest dividend risk
The equally-weighted nature of the portfolio has been one of the major contributors to the Fund’s outperformance during the recent correction - especially as some of the most popular (and highest yielding) FTSE 100 stocks were the hardest hit during the sell-off. As a result, our analysis shows there was a direct correlation between the worst performing funds during the sell-off and those with the highest dividend risk. Data from Morningstar shows, for example, that the average reliance on top 10 holdings for yield generation among bottom quartile funds is 51.47%.
The end of an extraordinary era
Furthermore, many of the worst performing funds have been popular offerings with high weightings to defensive growth or bond proxy stocks. This is because this sell-off, in our view, signals a regime change in markets. We expect to see a greater focus on earnings growth, increased caution in valuations and questioning of the perceived ‘safety’ of earnings visibility. The recent correction was sparked by inflationary/growth fears and rising bond yields, a risk we identified going into the year. As a result, some of the worst performing areas over the course of 2018 so far have been ‘defensive’ sectors such as healthcare, consumer goods and utilities (which the Neptune Income Fund is underweight). The more cyclical areas like materials and financials we are overweight, are among the strongest performers.
The Neptune Income Fund continues to be positioned for this ‘New Era’ in markets – which will, in our opinion, be driven by synchronised global economic growth, increased corporate profitability and an environment of free markets
The Neptune Income Fund continues to be positioned for this ‘New Era’ in markets – which will, in our opinion, be driven by synchronised global economic growth, increased corporate profitability and an environment of free markets, rather than the highly distorted backdrop of the QE years. Nevertheless, as this year’s correction and the various high-profile stock specific disappointments of the past 12 months have illustrated, we believe taking a diversified approach to portfolio construction via an equally-weighted strategy remains as important as ever for income investors.