‘No trade-off’: ESG income funds delivered both ESG and income
Morningstar research shows ESG strategies did not carry a yield discount relative to conventional peers
As a funds category, it is still early days for ESG income investing. In 2018, dedicated funds were a rare commodity. Now, there are 40 on the market collectively managing some $28bn.
With a few years of growth under their belt, the ESG income fund universe has generated a track record for investors to mull over. New research from Morningstar, that investigated the data, shows ESG income funds delivered both ESG and income.
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Growth era
The heyday of ESG income investing came in 2022 – 2023. That year, ESG funds accounted for 13% of the global income category. Growth has translated into maturity over time.
“After several years of rapid launches and strong inflows, the segment has matured into a structurally relevant part of the category, underpinned by a stable asset base, a diversified set of providers, and an established footprint that is unlikely to unwind”, the Morningstar report finds.
Regional variation characterised the market’s trajectory. Europe has led the way with America not far behind. Asia and the UK have some way to go.
“According to our data, the bulk of ESG assets globally are within Europe”, says Henry Ince, a fund analyst for equity strategies at Morningstar and one of the authors of the report.
ESG promises
Morningstar’s research also examined holdings within the funds and assessed these against internal ESG risk metrics.
The data shows that on average, three-fourths of total assets in ESG income portfolios had a ‘low’ or ‘negligible’ degree of ESG risk. Carbon risk metrics tell a similar tale. 72% of global ESG income funds have a higher allocation to low carbon risk assets.
Underlying analysis revealed this had to do with screening. ESG income funds tend to apply exclusion screens, for instance for thermal coal exposure, to construct their portfolios. They do so more often than their conventional peers.
“ESG funds primarily reduce exposure across key controversial categories such as alcohol, thermal coal, tobacco, military contracting, and nuclear”, the report concludes.
Exclusion of carbon intensive assets does not directly translate into the direct inclusion of climate solutions such as renewables or battery makers. ESG strategies typically have higher relative exposure to healthcare, real estate and technology companies.
Discounts and premiums
Theory dictates that holdings shape the yields on offer. For Ince and the research team, this was a point of enquiry.
“Our overall starting point was that to get income you need to buy oil, gas and other higher payout sectors”, he explained. The evidence refuted that hypothesis. “What we found was there isn't a definitive dividend discount by buying an ESG strategy”, Ince notes.
In the case of 159 EMEA-based income strategies, ESG funds delivered an average yield of 3.7% marginally outpacing conventional peers at 3.4%. “ESG and income are not a trade-off”, the report claims.
The twins
Ince says yield dispersions had other drivers, the most critical of which was underlying portfolio construction.
The difference in portfolio construction across conventional and ESG funds is most pronounced in the case of twins – asset managers running both strategies in parallel.
Kempen, a fund manager with both ESG and conventional income strategies offers a case in point. Morningstar’s analysis shows that both portfolios have a lot in common. Both have a common philosophy for diversification, stock selection and reward profiles. Both integrate ESG risks into investment decisions. Both are run by the same team. Fidelity and DWS twin funds also tell a similar tale.
Key differences emerge in ESG exclusions and portfolio constraints. Energy sector exposure is the only tangible difference between the two. Kempen’s ESG offering excludes Total, Shell and BP for instance. At times, this influences discounts.
“When a manager runs a conventional strategy alongside its sustainable sibling (same team, same process), the sustainable version can yield less. The swing variable is conventional energy: structurally high payout ratios are excluded in full”, the report explains.
At the fund universe level, the data suggests ESG funds did not come at a yield discount. The devil is in the details. The reality differs by manager and portfolio construction. Noting the fund-level variation Ince affirms, “construction beats label”.
