UK equity income peer group too concentrated
Fund size and a herd mentality is limiting the performance of many UK equity income funds and is undermining the sector’s ability to provide diversification for investors, argues Martin Brown, manager of the Ignis UK Equity Income Fund.
“54% of income in the UK market comes from just 10 companies, and 69% comes from 20 companies*. Most UK equity fund managers cluster around these familiar names, meaning that the makeup of many UK equity funds is strikingly similar. If you were to pick at random one of the top 10 most popular stocks in the peer group, then on average, 8 out of 10 income fund managers would own that stock.” (See table 1).
Table 1 – UK equity income peer group concentration
| Peer group ownership | Peer group weighting | Ignis weighting | |
| Vodafone | 93.2% | 5.2% | 3.8% |
| Glaxosmithkline | 93.2% | 5.2% | 2.5% |
| Royal Dutch Shell | 84.1% | 4.7% | 2.6% |
| Astrazeneca | 93.2% | 3.9% | 0.0% |
| BP | 85.2% | 3.9% | 0.0% |
| HSBC | 75.0% | 3.5% | 0.0% |
| British American Tobacco | 79.5% | 3.1% | 0.0% |
| National Grid | 77.3% | 2.2% | 0.0% |
| Imperial Tobacco | 71.6% | 2.1% | 2.8% |
| BG Group | 61.4% | 2.0% | 0.0% |
| Average | 81.1% | 3.6% | 1.2% |
Source: Ignis (Lipper, January 2011)
Why is there such a high level of commonality in the sector?
“One might hope that it is because 8 out of 10 fund managers think that these are among the best income investment opportunities in the UK stock market, and as such, deserve a place in their funds. This seems like an extraordinarily consensual view towards the biggest stocks in the index. Do 8 out of 10 fund managers really believe that they can add value in the analysis of these mega-caps, whose every movement is pored over by hundreds of analysts worldwide?
“The next possibility is that the fund managers have no choice, and they need to invest in mega cap stocks in order to meet liquidity requirements for their funds. For perhaps the biggest few funds in the sector, investing billions on behalf of clients, this is a reasonable claim. If these funds moved further down the market capitalisation spectrum then they would end up with a dangerously large percentage of the company’s equity. However, this applies to a very small number of funds – those over £1 billion or thereabouts. For any fund with less than a £1bn under management, liquidity considerations should not prevent the managers from investing down the capitalisation scale. A manager with AUM of £1bn taking a 3% position in the largest stock in the FTSE 250 (ITV, market cap of £3bn), would end up owning only 1% of the company’s equity – hardly a problematic amount.
“It is possible that equity income fund managers favour mega-caps because they believe they represent something of a safe haven from the perceived volatility and risk of mid and small caps. If enough managers persuade themselves of this, then it becomes self-fulfilling, but only on a relative basis. All their clients suffer together if things go badly (and the reverse if things go well). However, on an absolute basis, absolutely no protection is conferred by size alone.”
What are the problems associated with income fund managers’ penchant for the same large caps?
“The issue was neatly characterized by the events surrounding BP last year. Before the disaster at the Deepwater Horizon rig, BP was the largest company in the FTSE 100, and paid over 10% of the whole market’s dividend. Despite its huge size, a failure in management led to an event which caused the share price to dive by 50% in two months, and for the company to cancel their dividend for the year. Of course, there may have been many good reasons why a fund manager may want to have had BP in their fund, and several Ignis funds had holdings. However, there is a difference between researching a company and coming to the conclusion that its dividend and share price offer good value, and simply buying a company because it is big and all your peers own it. If the latter is true, then you are not justifying an active management fee, and your clients would be better off owning a tracker fund.”
What is the Ignis approach to generating income in the UK market?
“The approach we take on the Ignis UK Equity Income Fund is simple. We build a portfolio of stocks that we believe exhibit potential for capital growth and a healthy dividend. The balance will be different in each stock, and we will take positions in some stocks that do not even pay a dividend if the prospects for capital growth are strong enough. We will never buy a stock simply because it is big and our peers own it. We do own positions in 4 of the top 10 stocks in the sector (table 1), but we own these companies because we think they are fundamentally attractive, not because their size affords us protection from relative performance. Also, on average, we own less of these stocks than our competitors, and so they contribute less to the performance of the fund.”
“We buy companies irrespective of their market capitalisation, and in general, find that there are more opportunities for decent growth and dividends in the mid and small caps. Less coverage from brokers means that there is more potential for fund managers to add value with their own analysis. This means that we end up with a fund that looks very different to our competitors.” (Table 2 and table 3).
Table 2
| Peer group ownership | Peer group weighting | Ignis weighting | |
| Lloyds | 43.2% | 0.9% | 3.9% |
| Vodafone | 93.2% | 5.2% | 3.8% |
| Cookson | 8.0% | 0.1% | 3.3% |
| Aviva | 59.1% | 1.0% | 3.3% |
| BT | 65.9% | 1.8% | 3.2% |
| Melrose | 23.9% | 0.3% | 3.2% |
| 3I | 19.3% | 0.3% | 3.1% |
| GKN | 23.9% | 0.4% | 3.0% |
| Babcock | 17.0% | 0.2% | 2.8% |
| Northern Foods | 6.8% | 0.1% | 2.8% |
| Average | 36.0% | 1.0% | 3.2% |
Source: Ignis (Lipper, January 2011)
Table 3
| Mega cap | Large cap | Mid cap | Small cap | |
| Ignis UK Equity Income | 16.03% | 17.14% | 35.96% | 24.11% |
| UK equity income peer group average | 44.15% | 20.32% | 23.35% | 8.98% |
Source: Ignis (Lipper, January 2011)
Why is this attractive?
“The Ignis UK Equity Income Fund has a process designed for strong performance of capital and income. In addition to this, it can provide much-needed diversification in a peer group populated by lookalikes. As explained above, when comparing the underlying portfolios of many UK equity income funds, you will find a large degree of commonality and this will often result in high correlation of performance between the funds. Therefore, setting two of these funds alongside each other will offer an investor little in the way of diversification benefits. However, using the Ignis UK Equity Income Fund alongside a competitor would provide a more rounded, diversified exposure to equity income. As an investor seeking income from equities, it is a risky approach to restrict your capital to a small pool of mega-cap stocks. By widening your remit slightly, you can diversify your returns and benefit from the better opportunities located elsewhere in the market.”
FTSE Income Concentration
| Rank | Stock | Sector | Income weight (%) |
| 1 | Royal Dutch Shell | Oil & Gas | 11.72 |
| 2 | HSBC | Banks | 8.31 |
| 3 | Vodafone | Mobile Telecoms | 8.06 |
| 4 | GlaxoSmithKline | Pharmaceuticals | 6.08 |
| 5 | BP | Oil & Gas | 5.65 |
| 6 | British American Tobacco | Tobacco | 4.13 |
| 7 | Astrazeneca | Pharmaceuticals | 3.80 |
| 8 | National Grid | Multi-Utilities | 2.26 |
| 9 | Tesco | Food Retailers | 2.13 |
| 10 | BHP Billiton | Mining | 2.08 |
| Top 10 | 54.22 | ||
| 11 | Standard Chartered | Banks | 1.87 |
| 12 | Diageo | Beverages | 1.74 |
| 13 | Imperial Tobacco | Tobacco | 1.63 |
| 14 | Rio Tinto | Mining | 1.56 |
| 15 | Unilever | Food Producers | 1.53 |
| 16 | Reckitt Benckiser | Household Goods | 1.42 |
| 17 | SABMiller | Beverages | 1.42 |
| 18 | Aviva | Life Insurance | 1.20 |
| 19 | Centrica | Multi-Utilities | 1.19 |
| 20 | BAE Systems | Aerospace & Defence | 1.05 |
| Top 20 | 68.83 |
*Source: Evolution Securities (Jan 2011)
Past performance is not a guide to future performance. The value of investments can go down as well as up and are not guaranteed.