How to build an ESG income portfolio

How to build an ESG income portfolio
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Two of the biggest challenges facing advisers in the near term are how to achieve a decent level of income for clients in decumulation and how to invest in a sustainable way.

But the challenge is even greater when an adviser is faced with the prospect of dealing with both of those challenges in one portfolio, by investing sustainably for income. 

As many of the equity sectors traditionally favoured by equity investors include oil, mining and tobacco, many are unlikely to be in sustainable equity portfolios. Many of the staples of sustainable portfolios, such as renewable energy, are early-stage businesses that may not yet be at the point of paying dividends.

Simon Holmes, director and portfolio manager in the multi-asset team at BMO, says: “It is the case that traditional sources of income include several areas that would be excluded from a sustainable portfolio, such as tobacco and fossil fuels.

"Options for income seekers are indeed narrowing, with sectors that traditionally provide the highest yield also [being] the most impacted, and most greatly exposed, to disruptive trends, including the retail and banking sectors. This means investors who are chasing dividend-paying companies could find themselves in value traps or overexposed to sectors in permanent decline and/or with volatile dividends – such as the tobacco or energy sector."

He adds: "However, by investing in companies whose products and services contribute to solving some of the world’s most pressing sustainability challenges, not only do they have a direct positive impact on the world, but they will also benefit from long-term secular tailwinds. This ensures they can generate robust and growing streams of cash flows that underpin secure and growing dividends.”

John Teahan, equity income fund manager at RWC, says: “The challenge with sustainability is defining it. For example, electric-car-makers need copper, demand for copper will rise sharply in the years to come as people focus on that, but it is the traditional miners who are copper producers. So if we want to transition, we need the miners, and demand could be four to six times the current level.” 

He notes that certain mining companies are “more green than others, but one thing we want to do is work with the miners who are improving their safety and risk controls, for example".

Teahan adds: "On the oil side, you have a process where companies are using the cash flows they generate from their current activities to fund renewable energy investment, and we need that investment. Of course, not all oil companies are behaving in that way, but those that are need the support of shareholders.”

He says value investors tend not to buy the established renewable energy players on valuation grounds, but buying the companies that environmental, social and governance funds may not buy, in areas such as mining and oil, represents an opportunity.