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European dividend funds biased toward regulated sectors, says Fitch

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Fitch Ratings says investors should carefully review the investment processes of European dividend fund managers.

This oversight is necessary to ensure that forward looking analysis on dividend sustainability is at the core of the analysis.

Investors need to be aware of the more constrained investment universe of dividend funds, leading to sector biases against broader European equity funds.

With 40 per cent of portfolios on average, dividend funds are overweight in financials, utilities and telecoms, which naturally have higher levels of regulation compared to other sectors. The sustainability of dividends in these sectors needs to be carefully considered, given recent examples of regulatory decisions (e.g. utilities in Germany, telecom in France or banks throughout Europe).

Historically dividend yields have offered a significant enhancement to performance, notably in a low return environment. Higher dividend European stocks as defined by MSCI currently yield two per cent more than broader indices. However, Fitch says the consideration of the sustainability of dividends is key to performance and managers need to reconcile a quality growth focus with a dividend focus.

Managers tend to screen stocks by dividend yields, which can be backward looking. They need to develop a thorough strategic analysis covering barriers to entry, pricing power and structural sector trends, as detailed in Fitch’s special report. Although the above sectors were higher yielding in the past, there is no guarantee they will be in the future, with the possibility of excessive portfolio turnover occurring as funds rebalance to new high yielding stocks.

Those sector biases have weighted on the performance of dividend focused funds. They underperformed broader European equity funds over five years by 2.0 per cent, whilst exhibiting greater volatility (20.8 per cent vs. 18.1 per cent annualised over five years). Over three years, performances were in line, but with slightly higher volatility for dividend funds. Fitch’s peer group of dividend funds are on average overweight 13 percentage points in Financials, Telecoms and Utilities against the average of the Lipper Global Equity Europe peer group. Certain funds are overweight up to 30 percentage points in these sectors.

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