UK equity income – why domestic funds might look overseas

UK equity income funds are popular with investors and it’s easy to see why. They have potential to pay investors an income, while trying to grow their investment over the long term.

The UK stock market has a long tradition of paying dividends, which have historically added more to returns than they have in other global markets. The reliability, size and longevity of this dividend paying culture is attractive to investors, especially when interest rates are low.

UK equity income managers have some flexibility with their funds though. While they mainly invest in UK companies, they can invest up to 20% in overseas companies. In this article, we look at the reasons for looking overseas and what this can mean for investors.

This article isn’t personal advice. If you’re not sure if an investment’s right for you, seek advice.

UK dividends – the state of play

Over recent years the UK stock market has underperformed overseas markets. The lack of high-growth sectors, together with the EU referendum result in 2016, have contributed to the UK being out of favour with investors. The UK’s become a smaller part of the global investment universe, falling from about 8% of world stock markets ten years ago to around 4% today. On the other hand, the pool of potential overseas opportunities has become deeper and larger.

The concentration of dividends in the UK has also increased dramatically. Oils, pharmaceuticals and banks now dominate the UK dividend-paying landscape. Great if you’re a fan of these sectors and are looking for income, but this can bring some problems. Having fewer areas to invest in for income can increase risk as it means you’re now relying on just a few sectors instead of lots of different ones.

The pandemic thrust these dividend worries into the spotlight. UK companies cut their dividends by 33% through 2020, more than many other market. Lots of these have since been reinstated. But some industries like tobacco and energy, which are usual UK dividend payers, look like they could face some headwinds in the long term.

There are also industries less well represented in the UK that could have good long-term prospects for growth and income. The technology sector makes up less than 2% of the UK market, but over 20% of global companies. Healthcare can be a popular area for income, but the choice in the UK is essentially limited to AstraZeneca and GlaxoSmithKline.

The case for looking overseas – what the experts think

Looking overseas broadens the opportunities for fund managers, though it can also introduce issues like foreign taxes and currency fluctuations. The availability of companies paying out more in different industries and countries helps diversify income, increasing portfolio diversification and spreading the risk.

Over the past ten years investments in overseas companies within the IA UK Equity Income sector have doubled to near 20%. We recently spoke with the managers of our UK Equity Income Wealth Shortlist funds to hear their views.

Troy Trojan Income consistently invests more in overseas companies than most others. They look for attractive industries that are less represented in the UK, like software. Some software companies have generated plenty of cash which has helped dividends grow. They can also be defensive, holding up well in tougher markets, which appeals to Troy’s investment philosophy.

Paychex, the HR and payroll firm, is an example of a US software company that has offered a healthy mix of growth and good dividends in the fund.

Adrian Frost, long-standing manager of Artemis Income, has invested overseas for a number of years. He favours the flexibility to invest in similar themes available to him in the UK, but often with better growth prospects. Alternatively, he likes companies that bring something completely different to the fund.

For example, he holds the American-Dutch Wolters Kluwer, which shares similarities to the UK’s Relx, and Nordea from Finland, which he thinks offers better value and growth than UK options. Finally, the Dutch-listed food and biochemicals company Corbion offers a unique opportunity not available in the UK.

Ben Whitmore, who manages the Jupiter Income fund, has also invested in overseas companies for many years. These investments have helped the fund’s returns in the past. He believes good value and often more robust companies can be found in an expanded global universe. For example, he holds Europe’s Airbus, which he thinks is on a stronger financial footing compared to Rolls Royce or UK airlines. He thinks this can also help reduce risk.

Marlborough Multi Cap Income manager Siddarth Chand Lall invests less overseas than some other managers. He favours smaller companies, which often make more of their earnings from the UK but are riskier than larger companies. To increase diversification, overseas investments include the Norwegian lower-cost exploration company Lundin rather than Royal Dutch Shell. Chand Lall feels it’s important the fund provides something different from other equity income funds.

Not all managers agree though. Chris Murphy, who manages the Aviva UK Listed Equity Income fund, believes investors choose UK equity income funds to invest in the UK, not to rely on how well overseas shares do. UK companies also already make a large portion of their earnings overseas, so he feels it’s unnecessary to invest in other parts of the world.

Richard Colwell, who manages the Threadneedle UK Equity Income fund, also avoids overseas companies. Like Murphy, he believes investors choose a UK fund for investment in UK companies. This is where their expertise lies, and they feel there’s plenty of opportunity and choice in the UK.

Colwell also highlights the attractive valuations of UK shares against overseas ones, especially US shares. For example, he thinks consumer goods company Unilever, which has a long history of paying dividends, looks better value than a similar overseas company, Procter & Gamble.

You can find out more about a fund’s risks in their Key Investor Information Documents available on our website.

Remember, past performance isn’t a guide to future returns. All investments can rise as well as fall in value, so you could get back less than you invest.

What should investors take from this?

There’s no right answer on the case for looking overseas as a UK equity income fund. As you can see, our Wealth Shortlist managers all have different views and reasons for or against. We expect that though and think it’s healthy. It’s important that investors hold funds with a number of different investment styles. That way you could always have something doing well.

All of the managers have a clear focus on investing in only the very best UK income opportunities, and all invest at least 80% in the UK. Without compromising this philosophy, we think it’s sensible that selective overseas investment is considered if it fits with the manager’s strengths. If done well this can increase returns and diversification, while also reducing risk.

Investing in funds isn’t right for everyone. Investors should only invest if the investment’s objectives are aligned with their own and there’s a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest and make sure any new investment forms part of a diversified portfolio.

Editor’s choice: our weekly email

Sign up to receive the week’s top investment stories from Hargreaves Lansdown