“The Merian Global Equity Income Fund is less concentrated than most in the sector, and has less stock-specific risk. Unlike many active equity funds that are managed with an emphasis upon qualitative decision-making, this fund is run using a systematic process that uses rules and risk controls to make trading decisions in a methodical way.”
– Tom Poulter, head of quantitative research, Square Mile
The return of volatility to global equity markets has caused some anxiety among investors over recent months. Our proprietary analysis shows the worldwide deterioration in market sentiment and the risk environment since October 2017. The graph below shows market sentiment (horizontal axis) and risk environment (vertical axis) for five different regions (North America, Europe, Japan, Asia Pacific, and Emerging Markets). In October 2017, all five regions were showing optimistic investor sentiment and low risk (top right-hand corner of the graph). By December 2018 they had all fallen into pessimistic sentiment and high risk (bottom left-hand corner of the graph). Since then they have regained some ground, but are still much more pessimistic than previously.
Merian Global Investors’ proprietary analysis shows that market sentiment and risk environment, despite recent retracement, have both deteriorated since October 2017
Is dividend investing a safe haven?
At times of anxiety over stock market volatility, equity investors often turn to the relative stability of dividends. Over time, company dividend payments tend to be less volatile than companies’ share prices. The graph below shows the MSCI World Index (left hand axis) against the dividends per share of that index. Although the graph shows a steep decline in dividends during the 2008 recession – an extreme event by historical standards – in general dividends show steady and more stable growth.
Dividends tend to grow more steadily than share prices
Source: Bloomberg, as at 31 May 2019.
The greater steadiness of dividends, compared with share prices, may be due to company directors’ conservatism. Company directors may be reluctant immediately to cut dividends when profits fall. Similarly, when net profits rise, they feel a duty to share them with shareholders but are often cautious and refrain from upping dividends quickly in case the higher earnings prove temporary. In effect, company directors may be exercising a smoothing effect on dividends.
However, while dividend payments may be steady, stocks with high dividend yields are by no means those that outperform: in fact, over the last five years the opposite has been the case. Information Technology has the lowest dividend yield of all the sectors in the MSCI World Index (see graph below) and yet their shares returned more than any other sector over the five years to 31 May 2019. Many equity income funds exclude low dividend paying sectors like information technology, and this is part of the reason most of those funds have underperformed the broader equity market over the last five years. They have been too concentrated in dividend-producing sectors.
Source: Bloomberg, as at 7 June 2019.
A balanced approach
In the income funds managed by the global equities desk at Merian Global Investors, we favour a balanced approach that seeks to extract income from across the broader market, while remaining flexible in order to adapt to changing environments. For example, as at 30 April 2019, the Merian Global Equity Income Fund (IRL) had a weighting in the Information Technology sector of 16.3%, roughly the same as its benchmark, the MSCI All Country World Index’s, weighting in that sector (16.1%). By contrast, as at 30 April 2019, the largest fund in the Morningstar Global Equity Income sector had only 7.1% in the Information Technology; and the second largest had 8.2%.
Another problem is stock concentration risk. Traditional equity income funds that allocate disproportionately to stocks with higher dividend yields may contain hidden risks for investors, by exposing a greater proportion of their portfolios to a smaller number of stocks. As at 30 April 2019, the Merian Global Equity Income Fund (IRL) had just 10.7% of its portfolio weighting in its largest 10 stocks. By contrast, the largest fund in the Morningstar Global Equity Income sector had 26.5% in its top 10 stocks; the second largest reported that its top eight stocks accounted for 15.2%; and the third largest fund had 34.8% in its top ten. The principle of diversification means avoiding being over-exposed to individual holdings, and reducing unsystematic risk. The future can have nasty surprises in store for particular stocks, and it is therefore a sound investment principle not to have too many eggs in one basket.
We believe it is important to look outside of the more traditional sources of income-generating sectors and stocks. Global equity income investing needs a new approach. Adopting an unconstrained, total return strategy allows us to seek out what we believe are the most compelling investment opportunities. We believe that a focus on differentiated sources of alpha, rather than a concentrated style, is vital both to outperformance and to managing risk.