Sharing is Caring: Income Investing Meets ESG

VIDEO: Ollie Smith asks Morningstar Investment Management global chief investment officer Dan Kemp to explain the challenge of integrating ESG into income investing

Ollie Smith 26 November, 2021 | 12:45AM
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Ollie Smith: This week, my column on income investing touched briefly on the issue of ESG for income investors. So, here to talk to me about that in more detail is Morningstar Investment Management's Global CIO, Dan Kemp.

Dan, can you just tell me a little bit more about what the basic challenges are when it comes to integrating ESG into income investing?

Dan Kemp: Hello, Ollie. Of course, I'd be delighted to do that. Well, I think the first thing to remember when making an ESG investment is that it is an investment. And so, all the same rules apply as they would with any conventional investment. But there are a few things that you need to take into account. And one is that a typical ESG portfolio will hold different securities, different companies, from a conventional portfolio. And what that means is, you're drawing your income, your dividend income, from different companies. Now, the challenge for ESG investors is that a lot of the dividends available in the U.K. come from older style companies which don't screen as well from an ESG perspective. And so, you're likely to get less income if you're an ESG investor because you've excluded the companies that provide a lot of that income. So, that's on the equities, on the share side.

And then, also, the other part of the portfolio is normally invested in bonds and fixed income where you're lending capital to companies or governments. And again, you have different companies borrowing your capital in an ESG portfolio, potentially in different governments, and that can make a difference to the yield that you receive as an investor. So, same rules, just a few different things to infer.

Smith: In terms of risk, does that mean that ESG investors in this space should look at the topic of risk differently given who might or might not be involved on the other end at the companies or governments, as you say?

Kemp: It's not a different risk. You need to think about risk in exactly the same way investors should be obsessed with risk, certainly ESG investors, no less than anyone else. But the risks themselves are different. So, think about it the same way. But the risks are different. And that is that you tend to have these different holdings. So, the concentration of your holdings will be different. So, you have to think about concentration more carefully as an ESG investor than you would as a conventional investor. That's particularly true when lending money to companies because fewer companies included in the ESG universe, what normally happens is you have greater concentration, and of course, that means that your portfolio is a little less robust to all the things that could happen in the economy than a conventional portfolio would do.

Smith: Okay. So, I'm just going to play devil's advocate here for a moment. So, share buybacks, I think, are on my mind, and they've been criticized by certain commentators because they supposedly funnel money away from, say, the transition to net zero or perhaps communities or local infrastructure that companies rely on. Does that argument mean that companies that involve themselves in share buybacks would automatically fail the ESG tests? Or is it a little bit less black and white?

Kemp: That's absolutely wrong. The companies who are taking buybacks, or rather, provide returns to shareholders in that way are not disqualified from an ESG perspective. Share buybacks are simply a different way of providing capital to shareholders. It's a more tax efficient way typically to provide that capital, and also, it provides more flexibility to the managers of companies. Because unlike the dividend, which companies tend to commit to for years at a time and feel compelled to provide that dividend, share buybacks tend to be more opportunistic. So, it's just a different way of providing capital. Now, what you do with that capital when it's provided back to you is entirely up to you. And indeed, with companies, whether they send capital back to you or keep it themselves for reinvestment, then again, they should be judged on what they do with the capital, not how they distribute it.

Smith: Okay. I'm glad to have been proven wrong there. Dan, as ever, a massive pleasure chatting. More information on this and more, check out our income investing coverage for this week's special report week on Morningstar.co.uk.

Until next time, I've been Ollie Smith for Morningstar.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Ollie Smith  is editor of Morningstar UK