Equity income and sustainability have been seen as uneasy bedfellows. Investors point out that the higher dividend-paying sectors tend to be mature businesses in non-ESG friendly sectors such as oil or tobacco. Relatively few fund managers have attempted to blend the two strategies. However, are they really as incompatible as they seem?
The S&P Euro Dividend Aristocrats index would appear to illustrate the problem for equity income managers. Its largest weighting is in utilities, at 20.5%, currently the highest carbon-emitting sector. Its other significant weightings are in industrials (16%) and materials (15%), both environmentally-difficult sectors. It also has a chunky weighting in energy. Carbon-light sectors such as information technology are barely represented.
This incompatibility would also appear to be reflected in recent performance. This year, when many ‘old economy’ stocks have revived, equity income strategies have done well. In 2020, when sustainability was in the ascendancy, it was a horrible year for the high dividend approach.
But Stefano Montobbio, head of ESG and governance at EFG Asset Management, believes the reality is more nuanced: “If you follow the interpretation that ESG is an ethical investment, which I find too simplistic, then you might have issues investing in some high dividend sectors such as tobacco or energy. On the other hand, you might ask yourself if it is better to invest in a polluting company that is seriously improving its impact or in a non-polluting one that, precisely for its low negative impact, doesn’t bother to change.”
David Hogarty, head of strategy development at KBI Global Investors, agrees: “Our carbon footprint is significantly lower than the benchmark […] but achieving these ESG and low carbon outcomes requires a lot of deliberate management from the portfolio managers as, structurally, dividends tend to come from more mature (browner) companies and industry groups – although this has changed a lot in recent years.”
He says that even though utilities create the vast bulk of carbon emissions, within the industry group there is significant divergence. Some are successfully transitioning to a lower carbon business model, while some are being left behind.
He adds: “Stocks in our portfolio already run their businesses with less than half the emissions of their peers and have yields of about 3.5%. Rather than just avoid the problem, say by loading up on tech or healthcare, we think its important to invest in companies in the problematic industries that are trying to solve climate problems, otherwise nothing will change. It also enables more diversified portfolio for clients which is very important too.”
As such, equity income is a strategy that lends itself to an engagement rather than an exclusion approach. It has typically been hampered by a lack of diversification and a limited opportunity set, so excluding whole sectors such as oil and gas could be problematic.
That said, some groups will exclude smaller sectors such as tobacco, reasoning that while the world still needs oil and gas and many companies in the sector are an important part of the energy transition, it has no need of tobacco.
Montobbio adds: “In my view, within a sector, ESG should be used as a tool to better assess which companies strive to cut externalities – reducing their potential future ESG liabilities and risks – and which ones don’t.”
He argues that there are ways in which higher dividend strategies and ESG could actually be seen as compatible: “High dividend companies tend to have stable business, without many alternatives for growth or investments, so choose to pay back some capital to investors.
“Usually they are solid and well-established names with good processes, reporting capabilities and proper governance. You would expect all things being equal, that these companies have better ESG ratings than a growth company that needs to continuously reinvest, reinvent and expand the business.”
As long as investors are focusing on this type of business, rather than those where a high dividend implies some kind of distress, there may not be a conflict with a sustainability agenda.
Equally, Hogarty says the choice for investors is getting better: “We now find many of our more interesting holdings outside the traditional megacaps and higher yielding industries.” Certain green infrastructure investments, such as renewable energy or tower companies for example naturally lend themselves to an income approach.
That said, there remains a dearth of dedicated ESG equity income funds. While this could be a sign of the difficulty of blending equity income and ESG, it may simply be because equity income has been an unpopular and underperforming strategy for much of the past year and there has been relatively little incentive for companies to launch in this area. Last month saw Pimco launch its first ESG-focused income fund. Time will tell whether this is the start of a broader trend.
Montobbio says that finding the perfect equilibrium is a challenge, particularly as the ESG expectations from investors continue to mount. However, income and sustainability are not fundamentally incompatible and more products should come to market as equity income’s popularity revives.
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