Can you be an ethical income investor instead of going for growth?

Income seekers wanting ethical investments are currently limited to a fairly small selection of funds, while growth investors are spoiled for choice these days.

There are understandable structural reasons why ethical funds target growth companies, which tend to put all their extra money into expanding their business rather than distributing it to shareholders.

But it’s frustrating for investors who depend on a steady stream of dividends, and potentially a missed opportunity, as growth stocks have been struggling lately and many people are back on the hunt for income.

Below we look at why ESG investing – environmental, social and good governance – has so far failed to take off in the income sector and what options are available.

Why are ethical funds more focused on growth?

“Income investing and ESG are not the most sociable bedfellows because of the large share of market dividends paid by oil, tobacco and defense stocks,” said Laith Khalaf, chief of investment analysis at AJ Bell.

In addition, many of the companies involved in developing solutions to problems such as climate change are reinvesting their earnings into their businesses, rather than paying dividends.

Khalaf says we’re still at the forefront of ESG investing, but notes that if there really was a gap in the market, asset managers would probably have closed it by now, so the lack of income options could simply be a lack of demand reflect.

Dominic Rowles, chief ESG analyst at Hargreaves Lansdown, points out that 63 percent of UK equity funds invest in tobacco companies – with an average weight of just over 5 percent – 80 percent invest in oil and gas, 77 percent in miners, and nearly 60 percent in aerospace and defense.

“Historically, these sectors have traditionally paid some of the highest dividends in the UK stock market, with the current average returns of the UK’s two largest tobacco companies a staggering 6.6 per cent,” he says.

Becky O’Connor, Head of Pensions and Savings at Interactive Investor, says the lack of choice for sustainable funds focused on delivering income is especially a problem for people nearing or retiring.

“There is a clear need for more sustainable income products for the older generation of pension savers,” she says.

“Older pension savers can take less risk with growth-oriented funds, as lower performance can affect their retirement income and standard of living.”

II notes that growth as an investment style has struggled this year, as rising interest rates and inflation have prompted investors to rethink how much the future earnings of these companies are worth today.

What Should Ethical Income Investors Consider?

“Some investors may want more income but feel uncomfortable that their money could be used to support industries they believe are unethical,” Rowles says. “For those people, an income fund based on exclusions could be an option.”

But he cautions that while such funds have the potential to perform well over the long term, their performance will sometimes differ from more conventional funds and the broader stock market.

“If areas they can’t invest in do well, they could underperform unconstrained funds. This was the case last year as sectors like oil & gas and tobacco are among the best performing, and exclusions-based funds have missed these gains.

“But if these areas suffer a setback, one would expect them to outperform.

“By squeezing out some of the best-performing companies and sectors in the UK stock market, it also means that responsible income funds tend to pay less than traditional equity income funds.”

Likewise, Khalaf warns that there are often structural biases within ESG funds that can lead to widely diverging market performance, “sometimes for the better, sometimes for the worse.”

“ESG funds in particular will often be weighted toward modest-sized companies, because many of the big beasts in the market are polluting users or producers of fossil fuels,” he says.

“As always, ESG investors should do their homework to make sure the fund they invest in meets the ethical preferences they’re looking for in their portfolio.”

Khalaf says that while income investors are generally older and may be relying on their assets in retirement or semi-retirement, some younger investors may also be tempted to buy such funds for total return because reinvested dividends are a source of exceptional growth over the long term.

II says that more cautious investors should ensure that their portfolios are well-diversified and balanced, without a strong preference for a particular style or market cap.

Ethical Income Funds Rounding Out

There aren’t enough funds in this field for investment experts to provide a full list of tips. However, below are a few to explore if you are interested in this area. Some strive for both growth and income.

Janus Henderson UK Responsible Income (Ongoing charges: 0.84 percent/revenue 3.7 percent)

Andrew Jones has been managing the fund since January 2012 and aims to provide investors with a good level of income in addition to capital appreciation over the long term, says Hargreaves Lansdown.

Jones excludes companies active in alcohol, weapons, gambling, non-medical animal testing, nuclear power, tobacco and fossil fuel power generation, but considers companies that generate power from natural gas if they have a clear plan to move to renewables energy.

Companies must also comply with the UN Global Compact, which focuses on human rights, labour, the environment and anti-corruption.

“Before adding a company to the fund, Jones conducts detailed ESG analysis and consults with company managers if he believes there is room for improvement,” Hargreaves says.

An investment of £10,000 made when Jones began managing the fund in January 2012 is said to have generated £6,132 in income.

The investment itself would have increased to £16,268. With income reinvested, the fund would have raised £24,300. The same investment in the UK stock market would be worth £20,625.”

“Jones has successfully grown dividends over the long term, which is impressive given the fund’s limitations.”

Baillie Gifford Responsible Global Equity Income (Ongoing charges: 0.53 percent/revenue 2.10 percent)

This fund aims for both capital growth and sustainable income over the longer term, according to II.

“The managers, James Dow and Toby Ross, exclude stocks in certain sectors, such as tobacco and alcohol, and follow the principles of the UN Global Compact,” it reads.

‘The fund is an attractive choice for those looking for high and growing income from responsible equity investments.’

Holdings include Novo Nordisk, Procter & Gamble, Microsoft and Nestle.

Climate Assets Fund (Ongoing charges: 1.17 percent/revenue 2.50 percent)

The goal is to achieve long-term growth as well as revenue, and II says Quilter Cheviot’s manager, Claudia Quiroz, has been working since 2010.

She focuses on companies trying to solve some of the world’s long-term challenges, such as climate change, resource scarcity and population shifts.

The fund is multi-asset and is currently divided into 63 percent equities, 18 percent bonds and 11 percent alternative investments.

“The fund is in IA Mixed Investment 40%-85% Shares and is suitable for investors with a balanced risk appetite who want to invest in the growth markets of sustainability and environmental technologies, but with lower return volatility,” says II. .

EdenTree Responsible and sustainably managed income (Ongoing charges: 0.78 percent/return 4.80 percent)

CT Responsible Income in the UK (Ongoing charges: 0.81 percent/revenue: 3.80 percent)

Jupiter Responsible Income (Ongoing charges: 0.95 percent/revenue: 2.90 percent)