The portfolio construction process requires a decision on what asset classes to include and how much of each to include. It could be an allocation to stocks, bonds, cash or alternatives. Usually, it is a combination of many asset classes. The process involves comparing the risk and return requirements to accomplish your investment goal with the risk and return expectations of each asset class.

Morningstar has asset allocation models that range from Conservative to Aggressive. Every one of the models has an allocation to international equities. However, in practice, many Australians have no or minimal international equity exposure.

This may be because of familiarity with local companies and the local geo-political environment. It may also be due to a preference for characteristics of the Australian equity market when compared to international markets, namely high dividends and franking credits.

The average dividend yield of the ASX is 4.29% according to S&P Dow Jones (at 31 March 2024). The widely followed S&P 500 index which tracks the 500 largest companies in the US yields 1.44%. It is easy to see why income investors exhibit home bias. And that is before accounting for franking credits.

The ATO provides the monthly average franking rebate yield on the S&P Dow Jones All Ordinaries Index. Between 2018 and 2022 the monthly average is 1.25%. This will vary for specific investors depending upon the individual shares in a portfolio but is useful to look at the overall index. 

The important disclaimer to this data is that it is based on indexes. There are individual securities that are more focused on distributing capital to shareholders. Combining the average yield of a share trading on the ASX and the franking credit rebate, you need a yield of 5.54% or more from an international share to beat the average yield of the Aussie market. For example, the top dividend picks from our US colleagues have a range of yields from 2.83% to 8.92%. If the criteria is to exceed the ASX 200 only some shares would meet the mark. 

That does not mean that an income investor should ignore global markets.

Reasons to consider global income shares

Diversification from Australian market

Living and working in Australia links each of us to the Australian economy. Owning real estate in Australia is a further link. A portfolio filled with Australian companies provides even more exposure. Both the local economy and the share market are heavily reliant on the fortunes of the resource and financial sector.

The inherent concentration risk in the Australian market can be reduced by including individual shares while adding sector and geographic diversity. That provides protection from poor local economic conditions or issues in sectors that are over represented in Australia. 

Dividend growth

A focus on current dividend yields may not be the best approach for all income investors. Dividend yields are based on historic dividends. A high dividend yield is not an indication that the current dividends will continue in the future. Income investors relying on income to support current spending need to consider the sustainability of the dividend.

Even if the yield is sustainable the potential for future dividend growth may be impacted by a high payout rate. The payout ratio is the portion of earnings that are paid out as a dividend. Capital allocation is a balancing act for a business. Capital can be used to strengthen the balance sheet, grow the business or can be distributed to shareholders as dividends.

If most of the earnings are paid out as a dividend, there is less left over to reinvest in the business. A high payout ratio may also be a signalling mechanism that management does not see opportunities for growth. Ultimately a dividend cannot grow over time unless earnings grow. Lower earnings growth means lower dividend growth.

If you are an income investor, even in retirement, you may have a multi-decade time horizon. If dividends aren’t growing your income stream isn’t keeping up with inflation and your living costs.

Historically dividend growth has been a problem for Australian shares. Dividend growth per share for ASX listed shares has been 3.70% annually over the last 10 years. The S&P 500 has grown average dividends per share by 7.82% over the same period.

3.7% growth is higher than the RBA’s long-term inflation target. However, it has not kept up with inflation in the past couple years. Investing internationally can provide a buffer during periods of high inflation.

The payout ratio is not the only differences between the way that Australian and US companies manage their dividends. Australian companies tend to set a payout ratio. When you combine that with cyclical industries like mining, you get a lot of variability in dividends. This can be difficult to predict and manage as part of a dividend growth strategy. In the US, there is more stigma around cutting dividends. This results in steadier dividends and continual growth even if it comes from a lower dividend yield.

Considerations for global income investors

Currency fluctuations

Currency changes influence global returns and the amount of income received.

Portfolios are a balancing act between risk and return. Currency fluctuation is a risk, but that must be balanced with the benefits of owning global dividend shares.

Global portfolios

We can see the stark difference between the hedged and unhedged version. In this case, we can see that having currency exposure to the USD has resulted in favourable outcomes for investors. If the AUD falls in relation to the USD it is a positive for Australian investors in US shares. However, this won’t always be the case. This is where the bucket portfolio method may protect investors that are using income to fund their life. Cash can be a buffer against the volatility that currency brings to international investments.

Distribution frequency

If you are investing in the US, equities the standard is to distribute dividends quarterly, instead of half yearly like in Australia. Depending on the companies and instruments that you choose, it is important to take this into account when considering your investment strategy. Investors may consider quarterly dividends an advantage. Not only is cash distributed more regularly but quarterly dividends compound faster if they are reinvested.

Taxation

Earning income means that you will be taxed. I talk about how international investments are taxed in this article.

Conclusion

It is normal to have a bias towards domestic equities. It is especially so in Australia, where our markets provide impressive and consistent yields and tax advantages through franking credits. It is easy to fall back on the familiarity of domestic equities. Yet this overreliance on local shares denies the opportunity for protection from inflation from faster dividend growth, to profit from capital growth and diversification from a concentrated local market.

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