With the Reserve Bank of Australia slashing the cash rate to a new record low of 0.75% the thirst for income, particularly amongst retirees, is becoming even more desperate.

It’s no surprise, many investors are turning to the share market for dividend income.

In this search for income, few investors are looking beyond the ASX and a basket of just five shares, mainly banks. This is true for investors choosing to self-manage their share portfolios and for those choosing other listed products, such as ETFs.

The Australian concentration risk explained

Australian investors have the highest home country investment bias of any developed market in the world.

We believe this ongoing concentration risk is one of the biggest threats facing Australian investors, particularly retirees.

The chart below compares home country bias of investors in the US, The UK and Australia.

Investor 'home country bias'
Source: Morningstar ‘Diversification means investing overseas too’ 14 June 2019. Data from IMF survey 2011.

Australians have as much as 75% of their share portfolios in Australian shares while the ASX makes up only 3% of the size of global equity markets. This suggests an overweighting of more than 70% to local shares, compared to just under 30% for North Americans and just over 40% for UK investors.

If you dig a little deeper into the stocks that make up the Australian red overweight bar, the results show a staggering overweighting towards a handful of shares, mainly the banks, adding to this concentration risk.

Australia listed asset class composition
Source: Class SMSF benchmark report 31 March 2019.
Top 5 Australian shares in SMSF portfolios
Source: Class SMSF benchmark report 31 March 2019.

The pie chart above shows the large weighting towards individual shares in self-managed super fund (SMSF) portfolios. The bar chart indicates the four banks and BHP make up the top 5 holdings of the share portion of the total average SMSF portfolio.

The chart below further demonstrates the concentration risk the average Australian SMSF investor takes on, by adding Telstra and bank hybrids to the examination of SMSF investment portfolios.

You can see a total of 24% of the average Australian SMSF investment portfolio (i.e. excluding residential and commercial property) is made up of bank hybrids (at 5.3%) and the top 6 shares (at 19.0%), being the big four banks, Telstra and BHP.

Exposure to hybrids, bank shares, Telstra and BHP
Source: Class SMSF benchmark report 31 March 2019, Omega Global Investors figures are based on actual portfolio holdings and weights as at August 2019.

The Pinnacle aShares Global Dynamic Income active-ETF (ASX:SAVE), by comparison, has 0% of its portfolio in hybrids or those top 6 shares.

With hybrids now yielding a meagre 3.5% yield (down from 8% in 2016) and this handful of shares generating significant concentration risk to investors, SAVE aims to be an easy and affordable diversifier to the average SMSF portfolio.

Telstra’s recent dividend cuts speak for themselves and while bank stocks and particularly BHP have produced good yield over the past few years, investors should not ignore the single sector risk they are taking.

For the banking sector, the Financial Services Royal Commission that came to an end earlier this year should have been a wake-up call. Furthermore, after an extraordinary year of dividends, BHP warned of significant economic headwinds in its recent annual results.

The appeal of the high dividend yield of these stocks is understandably attractive but investors should remind themselves of the narrow sector and country risk they are taking when allocating such a large portion of their portfolio to these shares.

Global investing myths the cause of this concentration risk

We believe there are three stereotypes which are stopping income investors diversifying into global equities. They are:

  1. International equities are low dividend.
  2. Currency hedging can dilute income.
  3. Asset class selection is the biggest driver of returns.

First, let’s address the myth that international equities pay low dividends.  The truth is, on average, international equity benchmarks are low dividend.  However, high dividend paying securities exist which good investors and analysts should be able to identify.

The chart below demonstrates this. It compares income vs risk in Australian and global equities.  You can see a greater amount of higher income, lower risk securities available in global equities than Australian equities.

Source: Omega Global Investors. Risk = annualised standard deviation of returns. Income = trailing dividend yield.

Regarding currency dilution, some portfolio managers may not properly link foreign exchange income with the underlying income in their portfolios. Investors should be able to explicitly manage the FX income to the underlying securities.

While currency hedging is often seen as a solution, historically, it can be observed that the AUD has dropped as markets have fallen, providing additional value and protection to Australian investors when markets fall.

Finally, it is generally correct that asset class selection can be the biggest driver of returns, but we argue this doesn’t hold true for all equities and bonds.  It’s obvious that some listed securities can exhibit low volatility with high income. Combining equities and bonds in one portfolio can also provide investors with a lower risk portfolio when compared to a portfolio of equities only.

SAVE: A ‘One Stop Shop’ to this investor challenge

We believe it’s prudent for investors to be diversifying their exposure away from the Australian equity market when looking for income. There are so many opportunities available for them globally that are not being explored.

At Pinnacle aShares we believe a diversified portfolio of Australian and global equities and bonds can be a powerful ‘one stop shop’ when searching for income with lower risk.

This multi-layered approach to investing, which aims to maximise the benefits of diversification, can ultimately produce equity-like income for retirees and income investors, with bond-like risk.

This is what we aim to achieve with the SAVE active-ETF.

SAVE aims to pay monthly distributions and can be bought and sold just like any stock on the Australian stock exchange.

Author Chris Meyer

Chris Meyer is Director of Listed Products at Pinnacle Investment Management.

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