What a week…
As I’m sure you are aware, the chaotic spectacle of the slow-motion car crash we know as Brexit, has reached new heights over the last few days.
For a politics aficionado like myself, watching this is far more entertaining than the usual nonsense that clutters up the TV schedule every night.
However, I digress slightly. Whilst the Brexit shenanigans are no doubt interesting — to me at least — there is of course a very serious side to all this uncertainty.
One of our readers recently wrote in to ask:
“With all the uncertainty and chaos surrounding Brexit…should we be hedging (an income) portfolio?
…I know I’m nervous about the next few weeks and I have a feeling that as an income investor I am not on my own!
What’s your view?”
Great question. And, I’m sure they are not alone in being concerned.
I fully understand the concern. If you have any exposure to UK equities, then you will be fully aware that we are sailing through turbulent seas at the moment.
No doubt, there are international factors at work, such as the on-again, off-again, US-China trade war. But what’s really buffeting UK shares at the moment, is the ongoing farce surrounding our departure from the EU and the possibility of a Corbyn-led government.
Whenever the political pendulum swings towards a no-deal Brexit, Sterling plunges and those companies most heavily exposed to the UK economy, or those likely to be targeted by comrade Corbyn, quickly follow suit. When it looks like common sense will prevail and we will end up with a reasonable deal, the opposite happens.
And, with the bickering finally coming to a head, it is indeed a scary time to be holding UK equities. Or is it?
The specific question is about whether we should be hedging an income portfolio. In other words, is there something we should be doing in order to protect such a portfolio from a potentially substantial drop. My answer, in short, is no. Here’s why:
Firstly, if you have followed my advice for a while then you will know that I advocate only placing a portion of your nest egg into UK equities. You should also have similar levels of exposure to uncorrelated income-producing markets such as property, peer-to-peer, international income funds and possibly even cash and bonds.
So, a bad run in one particular asset class — UK equities in this case — will only affect a relatively small portion of your overall income portfolio.
As well as diversifying amongst asset classes, you should also diversify your share portfolio amongst a number of different sectors, and stocks within those sectors. If one specific sector or share gets into trouble, the impact will be minimised.
And secondly — as an income investor — you should try to avoid fixating on the current price of your shares. It is the dividend we are primarily interested in.
When I recommend equities, one of the key metrics that I look at is the forecast dividend yield. As a reminder, that’s the ratio of the forecast dividend amount compared to the current share price. So, if the shares are relatively cheap then the forecast yield is relatively high, and that could signal a good time to buy the shares.
Remember, that the actual dividend amount is not directly related to the share price, and so buying when the yield is high, allows you to “lock-in” a future dividend income stream at a great price.
Now of course, we all know that dividends can be cut. But assuming that does not happen, I will continue to receive the dividend payments, regardless of any gyrations in the share price. In fact, if we have picked the right shares, the dividend should actually grow over time. And again, that is unrelated to the prevailing share price.
So, my advice to income investors? Fixate on the level of the dividend payment and its future prospects, not the latest share price.
Thirdly, we are long-term investors. If you bought your shares at a reasonable valuation, then you shouldn’t need to worry too much. It’s quite normal for the price to bounce around in the short-term, but if you hold onto them long enough, there is every chance that they will end up worth more than the price you paid for them.
After all, ask yourself, what is the chance that you bought those shares at the highest price that they will ever trade at again? Of course, it’s possible, but if you have done your analysis well, it’s unlikely. And, while you are waiting for the price to return to your buy level, you should be raking in the dividends.
Fourthly, as you know, I love to sell covered calls against the UK stocks that I buy. That is primarily to bring in additional income that will usually at least double that earned from the dividends alone. That’s great, but did you realise that the extra option premium also acts as hedge and can offset some of the paper losses on your shares. If share prices drop, then the value of the call that you sold, also drops. So that’s a gain for you.
Therefore, it is quite possible to buy shares that subsequently drop in value but for the trade to still make an overall profit, once you include the premium from the covered call you sell. In many ways, this often-over-looked aspect of covered calls, should be their strongest selling point.
And one final thought. If you are still not convinced by my previous arguments, it is certainly possible to actively hedge your portfolio. You could buy puts on the shares that you own, sell futures contracts, or even stick on short spread bets. But, all of these approaches cost money and tie up your capital in ways that are not producing an income. And that, after all, is the name of the game.
So, no, I wouldn’t recommend hedging a carefully constructed income portfolio. To paraphrase the WW2 poster — Just keep calm and carry on enjoying the dividends.
As always, we would love to hear from you with any opinions, thoughts or general rants on the topics we write about. The email address is firstname.lastname@example.org.