There remains ‘significant concentration risk’ across the Investment Association (IA) UK Equity Income Sector, says a leading fund manager.

The latest analysis from Octopus Investments warns that the wave of dividend cuts in recent months demonstrates the need for ‘genuine diversification’ if investors are to avoid further instability to their income.

The number of UK equity income funds featuring oil majors  Royal Dutch Shell (RDSB) and BP (BP.) in their top 10 holdings has dropped materially during the coronavirus pandemic.

In January, Octopus found that 65% of funds in the IA UK Equity Income sector had Royal Dutch Shell in their top 10s holdings. But by the end of May, the percentage had almost halved. That widespread portfolio reshuffle came in the wake of the oil major’s first dividend cut in 80 years, with only 36% of funds now featuring the stock in their top 10.

A similar trend has been seen with BP, dropping from 61% of fund top 10 lists to 43%. BP ha , so far, not reduced its dividend but the FTSE 100 constituent BP remains the third most popular stock in the sector despite the real risk that it may yet do so.

Octopus’ analysis also reveals that Lloyds Banking (LLOY), HSBC (HSBA) and Legal & General (LGEN) have fallen out of the 10 most popular stocks. They’ve been replaced by Imperial Brands (IMB), publishing play RELX (REL) and Phoenix (PHNX).

RISK REMAINS

And yet, despite this portfolio reshuffling, Octopus finds that a large proportion of funds are still relying on the same stocks to generate income.

Chris McVey, the specialist small and mid cap stock picker who manages the FP Octopus UK Multi Cap Income Fund (BG47Q33), explains ‘income fund managers have had to adapt to the new environment, and many have rebalanced their portfolio in response. Yet as these figures show, the overall picture remains very similar, with significant concentration risk across the traditional UK equity income sector.’

In fact, drugs giant Glaxosmithkline (GSK) has strengthened its position and is now the most popular stock by some distance. It features as a top 10 holding in 80% of all funds in the sector. That is up from 76% in January.

‘Given how important this income is for the millions who use it to supplement their pensions, the dividend cuts of recent months should demonstrate the need for genuine diversification,’ insists McVey.

‘However, as this data shows, simply investing in different income funds won’t necessarily give you diversification. This makes it crucial to look closely at the underlying holdings.’

DIVERSIFY YOUR EXPOSURE

One option for income-hungry investors is the aforementioned FP Octopus UK Multi Cap Income, which puts money to work across the entire market spectrum.

Refreshingly, not one of its top 10 holdings – a list that includes the likes of fantasy miniatures maker Games Workshop (GAW), kettle controls group Strix (KETL:AIM) and healthcare IT supplier EMIS (EMIS:AIM), appear among the 22 most popular stocks across the IA UK Equity Income Sector.

Despite the recent volatility, the fund remained at the top of the sector in the year to 30 June, having returned 3.9% versus a sector average decline of 13.6%.

‘Our multi-cap approach shows that diversification is possible and provides the opportunity for investors to benefit from the significant number of companies capable of generating superior profit growth and attractive income, particularly further down the market cap spectrum,’ said McVey.

Within mid cap and small cap companies, he insists that ‘gems continue to be found, and they tend to outperform their larger peers, while demonstrating this faster growth in earnings and dividends.’

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Issue Date: 16 Jul 2020