The biggest threat to your retirement income

The demographic of Australian investor is getting older and with interest rates and bond yields falling to record lows there is a real thirst for income, particularly among retirees.

In search of this income, many investors are turning to the share market for dividend income, but few 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 bias is one of the biggest threats facing Australian investors.

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

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 over-weighting 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 over-weighting towards a handful of shares, mainly the banks, adding to this concentration risk.

 

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

While these bank stocks and particularly BHP have produced good yield for investors 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 dividend yield appeal 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.  

The cause of this concentration risk - global investing myths

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. 

Regarding currency dilution, historically portfolio managers have not properly linked foreign exchange income with the underlying income in their portfolios. Good managers of portfolios containing global shares and bonds should be able to explicitly manage the FX income linked to the underlying securities and use the FIX income as an additional source of income over and above the interest earned off the bond portfolio and the dividends from the share portfolio. There are still a number of countries where interest rates are lower than in Australia (think Europe and Japan) where investors can earn a positive FX 'carry' when hedging into AUD.

Finally, it is generally correct that asset class selection can be the biggest driver of returns, but we argue that some listed securities can exhibit low volatility with high income and thus security selection, especially in equities, also matters. Combining good equity selection with bonds in one portfolio can provide investors with an additional benefit of lowering the risk of a portfolio when compared to a portfolio of equities only.