The enduring case for global equity income

Read this article to understand:

• Why the AI boom has created headwinds for many active equity strategies
• The enduring appeal of income strategies and how managers of the strategy have looked to enhance their process
• Why global equity income strategies can be complementary to other popular strategies such as quality growth investing

Global stocks have had a stellar run in recent months, propelled to a series of record highs by an ongoing boom in spending on artificial intelligence (AI). However, this period has been far from straightforward for active managers of global equity strategies to navigate. 

Rarely has such a strong rally been accompanied by such high levels of dispersion – between international markets, but also within individual indices, sectors and even subsectors.

For instance, the difference in the volatility of the US S&P 500 and the average volatility of the benchmark index’s constituent stocks is at extreme levels. This is a direct consequence of the AI boom.

So far this year, the three leading technology subsectors (semiconductors, hardware and electronic equipment) have contributed over 70 per cent of global market gains. 

But while the AI boom may have floated an ever-expanding universe of stocks, the shares of plenty of other companies have been hit hard as investors scramble to identify not just the winners but also the potential losers.

They have even included some segments of the technology universe. For instance, shares in many software and IT services companies have sold off sharply.

While the market’s obsession with the AI theme has been especially problematic for value investors, it has also created difficulties for investors in equity income strategies. Naturally they favour dividend-paying companies which tend to be more mature and are often seen as defensive investments. 

Amid a clamour for shares in companies growing profits on the back of the AI boom, or at least expected to do so, more mature companies already paying high dividends or even those delivering attractive dividend growth, have tended to be overlooked.

A challenging period for income investing

Like the bulk of its peer group, this has weighed on the performance of Aviva Investors’ Global Equity Income strategy over the past 12 months.

While the strategy is designed to offer downside protection at times when markets are falling, the corollary is it will tend to underperform the broader market during strong rallies, such as that seen during that period.

One of the strategy’s two key objectives is to deliver 25 per cent more income than the broader market on an annual basis. The rationale being that that dividends and dividend growth are the most important drivers of total real equity returns over the long-term.

While the strategy does have sizeable exposure to several leading technology companies such as Google owner Alphabet, Microsoft and semiconductor group Broadcom, taken as a whole it has been underweight in the biggest US technology names.

This is partly because it is effectively precluded from owning companies such as Amazon and Tesla, neither of which pay a dividend. It will also tend to be underweight firms such as Nvidia, whose shares offer a relatively low yield. 

The managers believe there are more attractive ways to take advantage of the boom in AI-related investment by investing in companies further down the value chain that offer much more attractive dividend yields or the prospect of strong dividend growth.

Aside from Broadcom, examples include Taiwanese semiconductor manufacturer TSMC, and European industrial firm Schneider Electric, which manufactures electrical equipment used in data centres.

While the strategy continues to boast a solid long-term track record of offering downside protection against market downturns, it is important to acknowledge performance over in recent months has fallen short of expectations, including during the brief sell-off earlier this year after the US attacked Iran.

Enhancing investment processes

While disappointing, we believe this was an unusual period and does not significantly diminish the strategy’s long-term record of providing strong downside protection during market sell-offs.

Nonetheless, the managers have in recent months taken several steps to enhance their investment process to try to address the situation.

For example, it became apparent that the Global Industry Classification Standard (GICS) – the universal industry analysis framework used by financial professionals worldwide to categorize companies into consistent sectors and sub-industries – had some shortcomings.

The magnitude of market dispersion meant GICS was not providing sufficient granularity to discover where the best opportunities and biggest risks were located. 

So the team has added an extra layer of proprietary analysis by clustering together groups of stocks with common revenue drivers, called ‘risk buckets’. As a result, it identified insufficient exposure to memory-chip firms and responded by acquiring a stake in Samsung Group, which has a strong track record of dividend payments.

And while holdings have for some time been more geographically diverse than the benchmark, with US stocks making up close to half of total assets as opposed to 67 per cent of the benchmark, this had hurt performance.

The managers concluded that among the more defensive, higher yielding stocks they had exposure to, there was too much bias to European ones.

As a result, they took stakes in soft drinks manufacturer Coca-Cola and US electric and gas utility Public Service Enterprise Group. Coca-Cola in particular has an enviable track record of paying dividends, having grown its dividend every single year for over 60 years.

The strategy also underperformed the market during a near 40 per cent rally post ‘Liberation Day’ last year, after US President Donald Trump rowed back on some of his proposed tariffs.

The managers responded by increasing exposure to more economically sensitive stocks, most notably banks.

Historically banks had not formed a large part of the portfolio, with a key constraint the unreliability of their dividend payouts. However, the managers have taken stakes in three banks (straddling the US, Europe and Japan) with dividend payouts they believe will prove sustainable.

As there is no telling how long this fervour for all things AI will last for, this market bifurcation could persist for some time yet. However, it seems certain some of the speculative enthusiasm will eventually fade, even as technological advances spawned by AI continue to make their mark.

Managing the risks

The longer the monomania persists, the greater the risk facing investors. After all, the AI-led rally has driven concentration within the US stock market to unprecedented levels. For each dollar invested, 39 cents now goes into just ten companies, double the long-term average. 

Moreover, nine of these stocks are in just one sector – technology, if Alphabet, Amazon, Meta and Tesla are included. And the biggest seven firms are worth more than the combined market capitalisation of the next biggest seven countries. 

Similarly, some institutional investors’ equity portfolios have become increasingly exposed to a narrow set of return drivers via meaningful allocations to quality-growth strategies that often share similar characteristics – durable compounders, strong brands, high returns on capital and, in many cases, overlapping market leadership and industry concentration.

Global equity income strategies can act as a complement by offering a different route to achieving their objective: one anchored in free cash flow, dividend growth, income durability and valuation discipline.

Aviva Investors’ global income strategy deliberately incorporates three income buckets – Mature Yield, Core Yield and Income Growth – which allows it to balance downside resilience, compounding income and participation in rising markets. 

This makes it more core-like than a traditional income strategy, yet does not mean it is simply adding another exposure to the same quality-growth or technology mega-cap leadership investment styles already embedded elsewhere.

Rather, it can broaden the sources of return within overall institutional equity portfolios. It thus has the potential to complement existing quality-growth and broad global equity allocations by adding a differentiated source of income, resilience and total return.

Some equity investors might be tempted to find ways to protect their portfolio on the downside, after a sustained rise in share prices strengthened their financial position materially. 

The dilemma they face is that if they sell too early, they will miss out on the next leg of the rally. But sell too late and they will incur potentially big losses. Timing big market moves is notoriously difficult.

However, reducing risk need not necessarily equate to reducing their equity holdings. Investors concerned about valuations and mindful of concentration risk, can find plenty of attractively valued shares beyond the technology sector.

Indeed, while some areas of the global stock market look exorbitantly valued, others look far less expensive, especially those dividend paying stocks that have been somewhat out of favour. That is true even in the US, where share valuations look far less stretched after stripping out the technology sector. 

By investing in an income strategy, investors can simultaneously increase the diversification of their overall equity allocation, strengthen downside protection and boost their portfolio’s yield. 

Past performance is not a guide to future returns.